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Easy Bond ETF Trade Jolted Awake

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·7 min read
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Easy Bond ETF Trade Jolted Awake
Easy Bond ETF Trade Jolted Awake

There were rare signs of life in bond ETFs this week after data showed a faster than expected increase in wholesale and consumer price inflation.

The Core Producer Price Index in the U.S. increased by 0.5% month over month in July, according to the Bureau of Labor Statistics, the fastest increase since 2018. At the same time, the Core Consumer Price Index jumped by 0.6% in the same period, the biggest monthly increase in the gauge since 1991. 

The U.S. 10-year Treasury yield, which had been steadily dripping lower for weeks, spiked by 14 basis points after the release of the figures, reaching 0.72%, its highest level in two months. The yield has risen about 21 basis points since its nadir from earlier this month. 

While a 14, or even a 21 basis point move wouldn’t ordinarily be newsworthy, volatility in the Treasury markets had reached all-time lows in recent weeks, making what in the past would be a relatively pedestrian fluctuation into something more interesting.

The ICE BofAML MOVE Index, a measure of Treasury market volatility, dropped to a record-low 40.66 on July 30. At 45.26 currently, it’s still well below its historical average of 93.31.

ICE BofAML MOVE Index

With the Federal Reserve purchasing $80 billion of Treasuries per month and committing to keeping its benchmark federal funds rate near zero for years into the future, investors pushed Treasury prices consistently higher, and yields consistently lower over the past few months (bond prices and yields move inversely).

The Fed went as far as to hint that it may not hike rates even if inflation accelerates above its 2% target, a drastic shift in policy from before. Historically, the central bank has raised interest rates ahead of any jump in inflation.

With the Fed committed to its ultra-loose monetary policies for the foreseeable future, Treasuries were seemingly in a “can’t lose” situation when it came to prices. The U.S. 10-year Treasury yield dipped to an all-time closing low of 0.51% on Aug. 4; the five-year Treasury yield hit its lowest level ever, at 0.19%; and the two-year yield bottomed out just above 0.1%.

Yet as this week’s action shows, Treasuries might not be as immune from interest rate risk as some investors may have believed. With rates so low, it doesn’t take much for them to snap higher, though any rally in rates may be capped by the Fed’s endless support (offset to some extent by record-breaking issuances of new Treasuries to fund coronavirus relief programs).

US 10-Year Treasury Bond Yield

Stellar Year For Treasury ETFs

From an investor perspective, this week’s modest reversal in Treasury yields doesn’t really make a dent on returns. Anyone holding Treasury ETFs at the start of the year made out like a bandit; after all, rates are still extremely low historically.

The 10-year Treasury yield started the year at 1.92%, significantly higher than current levels. The iShares 7-10 Year Treasury Bond ETF (IEF), which tracks bonds of similar maturity, has returned a cool 10.9% so far this year.

The iShares 20+ Year Treasury Bond ETF (TLT), which holds longer maturities, is up 22.1%, and the iShares U.S. Treasury Bond ETF (GOVT), which holds a combination of maturities, is up 8.6%.

Lifeline For Corporates

In addition to pleasing Treasury investors, this year’s record low rates have been a lifeline for corporate bond issuers and ETFs.

Low Treasury rates drag down yields on corporates, though that can be offset by widening credit spreads, which are a reflection of the health of corporations’ balance sheets. Initially in March, when coronavirus fears were pummeling financial markets, those spreads blew out, but they’ve since come back in to more typical levels thanks to the Federal Reserve’s unprecedented steps to buy corporate bonds and corporate bond ETFs.

The Federal Reserve has enough capital set aside to buy $750 billion worth of corporate bonds, but it has only had to put a fraction of that amount to work—$12 billion as of July 31. The central bank could buy much more, it just hasn’t had to.

Animal Spirits

Its relatively modest purchases, which include more than $8 billion of bond ETFs, have been enough to ignite immense confidence in corporate bond markets. In fact, investors have been so confident that they’ve enthusiastically swallowed the record $1.5 trillion of bonds that U.S. corporations have issued in the first seven months of the year.

That includes $1.3 trillion of investment-grade issuances and $224 billion of high yield issuances, both amounts shattering previous records.

That huge amount of new bond supply has been easily absorbed. Indeed, both investment-grade and junk bond yields are trading at record lows in the U.S. As Bloomberg reported on Monday, Ball Corp. (BLL), a junk-rated issuer, was able to sell bonds with a yield of 2.875%, the lowest yield ever for a junk bond issuance.

(Use our stock finder tool to find an ETF’s allocation to a certain stock.)

It’s no surprise then that corporate bond ETFs have held up well this year. The iShares iBoxx USD Investment Grade Corporate Bond ETF (LQD) was last trading with a year to date gain of 8.1%. The iShares iBoxx USD High Yield Corporate Bond ETF (HYG) was down 1.3% in the same period, but that’s still quite impressive in the current economic environment.

Both funds are up substantially from their March lows, though the rally has pushed their yields close to record lows, potentially reducing returns for new investors. HYG’s latest 30-day SEC yield was just 4.44%, while the same yield for LQD was 1.88%.

The Fed’s Bond ETF Holdings

Note: Data as of July 31, 2020

Risks To Consider

After sleepwalking their way to gains over the past few months, bond investors were awaken by a sudden jolt of volatility. With the Fed backstopping the markets, it’s hard to imagine that yields will spiral higher from here in the short term, but a modest increase is certainly possible from such low levels.

Longer term, while rates could potentially stay depressed for years on end as the market currently imagines, interest rate risk hasn’t been completely done away with. A faster than expected rebound in the U.S. economy or a faster than expected acceleration in consumer prices are possibilities that could catch Treasury markets off guard, sending rates suddenly higher.

In terms of corporates, credit spreads could widen if economic conditions deteriorate more than expected. Or risk could enter the markets when the Fed’s corporate credit facilities expire at the end of the year (if they are not extended).

Investors must weigh those risks against the safe-haven appeal of bonds and the potential upside in price were rates to fall even further from here.

Email Sumit Roy at sroy@etf.com or follow him on Twitter @sumitroy2

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