The opportunity for bond ETFs now


Karen Veraa, CFA May 26, 2022

OVERVIEW

OVERVIEW

With rising interest rates, high inflation and geopolitical uncertainty driving market volatility, bond investors are looking for ways to position portfolios. Many are turning to bond ETFs to navigate today’s choppy markets.

 

More than $40 billion moved into global bond ETFs in the first quarter of 2022 even as a generational rise in inflation and tighter monetary policy resulted in sharp price declines for many bond benchmarks.1 For comparison, an estimated $150 billion moved out of global bond mutual funds over the same period.2

HOW ARE INVESTORS USING BOND ETFs?

HOW ARE INVESTORS USING BOND ETFs?

Investors are using bond ETFs for three main strategies:

 

1. Repositioning for rising rates and inflation. Bond ETFs are typically passively managed, meaning they seek to track the performance of specific segments of the bond market. This modularity empowers investors to easily implement both strategic allocations and tactical trade ideas. With uncertainty around rate hikes and inflation driving markets, flows show that investors have allocated to bond ETFs that target short maturities, floating rate securities, and TIPS, for example.

 

2. Harvesting tax losses. The Bloomberg US Aggregate Index — a broad measure of bond market returns — fell 9.5% during the first four months of 2022 — the worst start to a year in its history.3 Historically, though, returns have been positive on average following prior bond market drawdowns.

 

Additionally, 97% of mutual funds in the Morningstar Intermediate Core-Plus Bond category now have a negative three-year price return, suggesting that many investors may have losses in their bond portfolios.4 A common strategy is to “harvest” these losses for tax purposes and reallocate to ETFs to maintain market exposure. Of course, it is important to observe the wash sale rule when doing so.

Worst ever start to a year for bonds
Since 1926, bond market return through 4/30 for each calendar year

Bar chart showing the total return of the bond market through April 30th for the ten calendar years since 1926 in which performance through April 30th was most negative.

Source: Morningstar as of 4/30/22. U.S. bonds represented by the IA SBBI US Gov IT Index from 1/1/26 to 1/3/89 and the Bloomberg U.S. Agg Bond TR Index from 1/3/89 to 4/30/22. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.


Returns following the 10 worst starts to a year

Since 1926, bond market returns for the next 8 and 12 months

Caption:

Bond market returns from 1926 through April, 2022.

YearFirst 4 monthsNext 8 monthsNext 12 months
2022 9.5??
1994 3.6+ 0.8+ 7.3
1974 3.2+ 9.2+ 8.6
1981 3.1+ 9.7+ 17.1
2021 2.6+ 1.1 8.5
1996 2.3+ 6.1+ 7.1
2018 2.2+ 2.3+ 5.3
1990 1.7+ 10.9+ 15.2
1937 1.4+ 3.0+ 6.7
1987 1.1+ 3.9+ 7.3
Avg. 3.1+ 5.2+ 7.3

Source: Morningstar as of 4/30/22.
U.S. bonds represented by the IA SBBI US Gov IT Index from 1/1/26 to 1/3/89 and the Bloomberg U.S. Agg Bond TR Index from 1/3/89 to 4/30/22. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

3. Capturing higher yields while managing costs. This year’s selloff has increased the yields on most bond categories. For example, treasury bond yields have risen from 1.2% to 2.9% YTD, and the yield of high yield corporate bonds reached 7% for the first time since 2020.5 Bond ETFs tend to have low management fees, no loads and low transaction costs. These savings help contribute to investors keeping more of what they earn.

Bond yields have increased in 2022

Bar chart showing the yield of different bond market segments on December 31st, 2021, and April 30th, 2022. Yields rose during this period and are higher on April 30th, 2022 for all segments.

Source: Bloomberg as of 4/30/2022 US Aggregate represented by Bloomberg US Aggregate Bond index, Treasuries represented by the Bloomberg US Treasury Bond Index, US IG represented by the Bloomberg US Corporate Bond Index, High Yield represented by the Bloomberg US Corporate High Yield Bond Index, and Munis represented by the ICE AMT Free US National Municipal Index. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.


A TRAJECTORY FOR FURTHER GROWTH

A TRAJECTORY FOR FURTHER GROWTH

The current environment is unique and challenging, but the fact that investors are turning to bond ETFs does underscore why the industry is growing even faster than we expected. The transparency of ETFs allows investors to better understand the risks they are taking — a key element for building portfolios in any environment, but especially one marked by high volatility and uncertainty. iShares offers over 100 bond ETFs across core, credit, floating rate, ESG and term maturity strategies. This wide range of tools can help investors build more resilient portfolios as they pursue their goals.

 

It took 17 years for global bond ETF assets to reach $1 trillion. In 2019, as the industry approached this milestone, we forecasted that the market would double by the end of 2024.6 In our new paper, Bond ETFs Turn 20: All Systems Go for $5 trillion, we upgrade our outlook and project that assets in bond ETFs will reach $2 trillion in 2023 — 18 months early — and grow to $5 trillion by the end of 2030. If anything, we believe the challenges associated with high inflation and rising interest rates will attract more first-time ETF investors and prompt existing investors to find new ways to use these versatile investment tools.

Karen Veraa, CFA

Karen Veraa, CFA

Head of U.S. iShares Fixed Income Strategy