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How Yield Curves Move Bond ETFs

Luis Guerra

If you have read the latest news, you know that a lot of people are focusing on the yield curve and its current shape. This is because the term structure of the curve provides important information on market expectations for future economic growth and levels of inflation.

Moreover, the current curve shape resembles the one seen in the years 2006 and 2000, which would precede the “great financial crisis.” So, let’s take a closer at the curve’s recent action, how it is shaping bond ETF performance, as well as look back at other periods with a similar behavior.

 

Lower Yields, High Prices

As seen in the chart below, the yield curve has shifted downward in 2019, driving the outperformance of broad market bond ETFs (lower yields = higher bond ETF prices).

 


For a larger view, please click on the image above.

 

The Bloomberg Barclays Aggregate Market Index, a benchmark for the largest U.S. core bond ETFs, boasts a robust year-to-date total return of 8.78%. Because broad market bond ETFs hold a portfolio of several maturities, they have been the most convenient way for traders to gain access to the market.

Throughout 2019, they have gathered around $43 billion in new assets compared with only $7.6 billion in inflows last year.

Shrinking Spread

At the start of the year, the spread between three-month and 30-year maturities stood at 55 basis points. As of Aug. 15, the spread stood at a mere 7 basis points. This has caused long-term ETFs to rally. The iShares 20+ Year Treasury Bond ETF (TLT) and the Vanguard Extended Duration Treasury ETF (EDV) boast impressive total returns of 23.20% and 30.60%, respectively, as of Aug. 14, 2019.

Additionally, the three-month yield inversion is notable between the three- and five-year maturities. The spread between the three-month rate and the three-year is negative 0.49%, meaning intermediate bond ETF investors are willing to pay higher prices and receive lower monthly distributions than invest in ultra-short-term ETFs.

This market action hints that the Fed will cut rates by around 0.75% in the upcoming months. As of Aug. 14, 2019, the Schwab Intermediate-Term U.S. Treasury ETF (SCHR) and the SPDR Bloomberg Barclays Intermediate Term Treasury ETF (ITE) have year-to-date total returns of 7.34% and 7.37%, respectively.

An Inverted Humped Yield Curve

As a final note, while recent news headlines have focused on the inversion of the curve as well as short-term deflationary fears, few people have noted the rare inverted humped formation developing at the belly of the curve. This is a result of the uncertainty of the Fed’s medium-term policy.

This current yield curve formation resembles the term structure of the curve seen during three other time periods: October 1998, December 2000 and August 2006.

 


For a larger view, please click on the image above.

 

Each of those times were characterized by near-term uncertainty on future Fed policy action.

In 1998, the fear of contagion from the Asian financial crisis prompted the Central Bank to cut rates, but left the door open to further interest rates increases.

In December 2000, the Fed and markets were still weighing whether benchmark rates should decrease ahead of deflationary pressures at the time.

In August 2006, the Fed paused its tightening policy and left the door open for future rate increases or cuts based on upcoming macroeconomic data.

Where The Curve Steepens

Needless to say, today’s environment bears similarity to these past periods. Yet a key difference is that, in the current curve, key rates after the 10-year duration have steepened. The later action can be interpreted such that any cuts in short-term rates may be a temporary phenomenon, and inflation may show up on the midterm horizon.

It is a difficult time to forecast the yield curve’s next movements. Just a year ago, news headlines focused on rising rates and inflation worries. Instead, 2019 has been marked with lower yields and a marked inversion of the yield curve.

U.S. bond ETFs have performed incredibly well in this environment, especially long-term bond ETFs, as mentioned above.

At the same time, advisors can look at different strategies. For example, if an investor believes the curve will continue to shift lower, then core bond ETF positions and a satellite allocation to long-duration ETFs could be a good alternative to consider.

On the other hand, if the curve steepens, a core bond ETF position band with an overweight allocation to short-term ETFs should be an attractive option.

Contact Luis Guerra at lguerra@etf.com

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