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Will Bond ETFs Sustain Their April Momentum in May?

Sweta Killa
On today's episode of the Zacks Friday Finish Line, Associate Stock Strategist Ryan McQueeney and Editor Maddy Johnson take on this week's biggest stories, including the latest trends in luxury apparel and retail, Target's mixed earnings report, and recent trade concessions made by the U.S. and China.

The fixed income world gained immense investors' love in April amid persistent stock market volatility. This is especially true as bond ETFs accumulated $14.7 billion last month, representing the highest monthly inflows since October 2014, according to data from BlackRock (read: ETF Asset Report for April 2018: Bonds Top).

iShares Short Treasury Bond ETF SHV topped the list of asset creation, pulling in more than $2.5 billion. This was followed by iShares 20+ Year Treasury Bond ETF TLT, iShares Core U.S. Aggregate Bond ETF AGG and iShares Floating Rate Bond ETF FLOT with inflows of $1.7 billion, $1.6 billion and $1.2 billion, respectively. iShares iBoxx $ Investment Grade Corporate Bond ETF LQD and iShares 1-3 Year Treasury Bond ETF SHY gathered less than a million dollars in AUM.

Inside The Sweet Spot

The popularity rose despite the rise in yields that hurt bond prices. Notably, the 10-year Treasury yield touched a four-year high of 3.04% while two-year yields hit 10-year high of 2.5% (read: 8 Inverse Bond ETFs to Profit Out of Rising Yields).

Investors seeking protection from rising rates poured money into the lower-dated bonds like SHV and SHY. This is because short-duration bond ETFs are less vulnerable and act as a better hedge to rising rates. SHV and SHY have an effective duration of 0.44 years and 1.95 years, respectively.

Particularly, duration indicates the interest rate risk and is a measure of a fund’s sensitivity to a 1% change in interest rates. The longer the duration, the more sensitive the fund is to the changes in interest rates. This can be explained with the following example: consider a 10-year maturity investment grade corporate bond with duration of 8.4 years and coupon rate of 3.5%. If interest rates go up by 2% then the bond will lose 15% of its market value. On the other hand, the same investment grade corporate bond with duration of 14.5 years, maturity of 30 years and a coupon rate of 4.5% will lose 26% of its value if interest rates are raised by 2%.

Floating rate ETFs like FLOT protect investors from capital erosion in a rising rate environment. This is because floating rate notes are investment grade bonds that do not pay a fixed rate to investors but have variable coupon rates that are often tied to an underlying index (such as LIBOR) plus a variable spread depending on the credit risk of issuers. Since the coupons of these bonds are adjusted periodically, they are less sensitive to an increase in rates compared with traditional bonds. As such, unlike fixed coupon bonds, these will not lose value when the rates go up (read: Win From Rising Rates With These 4 ETF Strategies).

On the other hand, the risk-off trade led to the rotation from stocks to bonds thanks to inflationary pressures, a faster-than-expected rates hike, political instability in Washington, trade tensions, geopolitical tension, and technology sector turmoil. In fact, all these uncertainties raised the appeal for the U.S. government bonds tracking the long end of the yield curve. These products like TLT often carry a safe-haven status and seem a better pick amid market turmoil.

Bond ETFs like AGG and LQD enjoyed strong investors’ acceptance due to their investment-grade focus and spread-out maturity. AGG has average maturity of 8.18 years while LQD has 12.65 years in average maturity. A stronger economy backed by lower income tax and solid labor growth continued to drive these ETFs.

Investors should note that most of these bonds ETFs were in the red last month, with TLT losing the largest by about 2.4%. LQD and AGG were down 1.8% and 1%, respectively, while SHY shed 0.3%. FLOT and SHV gained 0.4% and 0.1%, respectively.

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ISHARS-20+YTB (TLT): ETF Research Reports
 
ISHARS-IBX IG (LQD): ETF Research Reports
 
ISHARS-1-3YTB (SHY): ETF Research Reports
 
ISHARS-FL RT BD (FLOT): ETF Research Reports
 
ISHARS-SH TB (SHV): ETF Research Reports
 
ISHARS-CR US AG (AGG): ETF Research Reports
 
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