What To Do About Bonds?

The last year’s topsy-turvy bond market serves up investor challenges.

Senior ETF Analyst
Reviewed by: Sumit Roy
Edited by: Sumit Roy

For many investors, fixed income allocations are the last thing on the list. Even enthusiastic individual investors are often obsessed with following hot trends, new IPOs or debating the benefits of smart beta.

But when it comes to their bond allocation, they use a quick rule of thumb and move on. Even financial advisors that we know are deep thinkers and great at math often just “buy the Agg” (the Bloomberg Barclays US Aggregate Bond Index) and maybe augment that with an ETF to capture, say, the junk bond market, or international debt.

But that’s a mistake for a lot of reasons. Consider what’s happened just this year with interest rates.

Whipsawing Rates

The path that interest rates have taken this year has been nothing short of dizzying, swiftly moving from an upward trajectory to a downward one. It may be hard to remember now, but only 10 short months ago, the Federal Reserve hiked rates to around 2.5%—a cycle high—following through on Fed Chairman Powell’s comments several weeks before that rates were “a long way” from neutral.

That’s all ancient history now. A ratcheting-up of tensions in the U.S.-China trade war, slowing global growth and a weakening U.S. economic outlook have all conspired to send interest rates sharply lower.

The benchmark 10-year Treasury yield, which peaked a year ago at 3.25% and entered 2019 at 2.68%, tumbled to as low as 1.44% in August—just a hair above its record low of 1.32% from 2016.

Similarly, the 30-year Treasury yield, which hit a 3.47% high last November and started 2019 at 3.01%, sagged to 1.9%—a new record low—even less than where it was in 2016.

Scrambling To Keep Up

The Fed has been scrambling to keep up with the market. It’s cut the federal funds rate twice by 0.25% so far this year, last putting it in a range of 1.75% to 2%. Investors are pricing in another rate cut for Oct. 31, and potentially even one more in December.

With the market moving rates lower much faster than the Fed, the yield curve has notably flattened. The yield on the three-month Treasury bill briefly fell below the yield on the 10-year Treasury bond in March. The inversion, which is seen as a recession indicator by some, deepened to as much as 0.5% in August.

Likewise, the spread between the 10- and two-year Treasuries, another closely watched part of the curve, also inverted in August.

Both curves have recently “uninverted,” moving back into a more normal upward slope, but barely so. The yield curve remains flat, with risks of further inversions if the Fed moves too slowly with rate cuts should they be necessarily.

Structural Factors

Even if economic pressures abate—for instance, in the scenario where a trade deal is struck—the yield curve may not steepen significantly. Feeble growth overseas has pushed international interest rates to astonishingly low levels.

The German 10-year bund was yielding -0.75% in August, and the equivalent Swiss yield was -1.15%. Even Greece, which was ground zero of the eurozone sovereign debt crisis a number of years ago, sold 13-week notes yielding less than zero earlier this month.

The current cyclical slowdown is certainly weighing on global yields. But so too are structural factors, such as the savings glut caused by an aging population and persistently low inflation brought about by technology.

Credit Spreads Tight

These factors seem to suggest that the old normal of 5%+ interest rates and a steep yield curve won’t return easily, if at all. So what’s a bond investor to do? The cold hard reality is that, to get those types of old-school yields, investors will have to search elsewhere, and almost everywhere is riskier.

Broad, investment-grade corporate bond ETFs still offer yields close to 3%. But you’d have to go all the way to the junk bond market to get yields in excess of 5%. That’s because credit spreads are still quite narrow, despite growing worries about economic growth.

What should an investor do, especially if they’re still looking to bonds to provide a modicum of safety and a little yield? Many investors might be surprised to see the yields and total returns so far this year on the shorter end of the bond market. Many of the ETFs in the segment have yields north of 2% (for very short duration exposure), and the rush to safety has bid those funds up even more than that this year—many are up over 6%.

We Have Help For You

So, is staying to the short side of things the right call? Our take is yes, but don’t take our word for it.

We’re doing a webinar next Thursday, Oct. 24, at 3 p.m. ET with someone much smarter than us on this stuff: Chris Harms, one of the better-performing short-term bond managers this year, from Loomis, Sayles & Co.

We plan on grilling him about how to position bond exposure for the next year, and to walk away with a much clearer picture of where the risks are, as well as the opportunities. I hope you’ll join us.

You can register here: “Positioning Your Bond Exposure for 2020”

Contact Sumit Roy at [email protected]

Contact Dave Nadig at [email protected]

Sumit Roy is the senior ETF analyst for etf.com, where he has worked for 13 years. He creates a variety of content for the platform, including news articles, analysis pieces, videos and podcasts.

Before joining etf.com, Sumit was the managing editor and commodities analyst for Hard Assets Investor. In those roles, he was responsible for most of the operations of HAI, a website dedicated to education about commodities investing.

Though he still closely follows the commodities beat, Sumit covers a much broader assortment of topics for etf.com, with a particular focus on stock and bond exchange-traded funds.

He is the host of etf.com’s Talk ETFs, a popular video series that features weekly interviews with thought leaders in the ETF industry. Sumit is also co-host of Exchange Traded Fridays, etf.com’s weekly podcast series.

He lives in the San Francisco Bay Area, where he enjoys climbing the city’s steep hills, playing chess and snowboarding in Lake Tahoe.