Fixed income ETF must-know: Has the bear market in bonds begun?

Fixed income ETF must-know: Has the bear market in bonds begun? (Part 1 of 5)

Check your fixed income ETF duration before it’s too late

Real GDP growth

The below graph reflects the long-term decline in the real (inflation-adjusted) economic growth rate in the United States, or gross domestic product, GDP. The dotted line captures the trend in inflation-adjusted growth rates in the USA, measured as a simple three-year moving average. With long-term average growth rates trending from 4.5% to 1.75% per year, it’s easy to see why the U.S. government had stepped in with increased government spending in recent years and run large budget deficits. However, it’s possible that economic growth could be on its way back to the historical average growth rates of 2.5% or higher, and this could mean a return to higher interest rates in the future—especially with respect to longer-dated bonds.

This series takes a quick look at past and present economic growth data, government spending, interest rates, and inflation, and considers the outlook for ETF-focused fixed income investors amid a rising rate environment. For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see, Must-know 2014 US macro outlook: The crack in the debt ceiling.

US Real GDP Growth Rates 2014-02-18Enlarge Graph

U.S. GDP growth: Is the recovery intact?

The economic crisis of 2008, as reflected in the above graph, led to a brief period of negative real economic growth. Essentially, the U.S. economy went into a tailspin and began to shrink, and the U.S. Federal Reserve began to lower interest rates in order to support the U.S. economy. Plus, the U.S. government began to run large deficits in areas such as unemployment insurance, as unemployment increased and the economy remained weak.

Changes in federal reserve monetary policy

For fixed income investors, falling interest rates meant an increase in bond prices. During the early phase of the economic crisis, the rapid loss in wealth attributed to falling stock prices was offset to some degree by rising bond prices. However, in the past few years, equity markets have finally regained their record-high levels, and housing prices have recovered roughly 40% of their peak-to-trough declines, based on the Case-Schiller Nationwide Index. As a result of stabilization of the U.S. economy—including asset prices, employment, and overall economic growth—the Federal Reserve has now begun to withdraw a modest amount of emergent economic support. The Federal Reserve Bank scaled back its level of U.S. bond purchases from $85 billion per month to $75 billion at the end of 2013.

Knowing your ETF’s bond portfolio duration risk is key

As the stock market has reached new highs, fixed income investors have seen bond prices fall, as long-term interest has begun to rise. The ten-year bond yield had been as low as 1.5% in July 2012, though it rose to 3.00% in December 2013, when the Federal Reserve began to change its monetary policy. For the holders of a new 10 Year US Treasury Bond, that means that for every 1% rise in the ten-year interest rate, the ten-year bond will lose 8.68% in its price, as 8.68 is the “duration” of the current ten-year bond. For example, if an investor had bought the ten-year Treasury bond at its high price or low yield of 1.5% in July 2012, their ten-year bond would have declined just over 12% in price (a 1.50% change in yield times the 8.68-year duration). However, the stock market (the S&P 500, SPY) gained 28% during the same period, offsetting the loss for investors who had also invested in the broader equity market. For more information on calculating the duration of your own bond investments, see the related Market Realist Series, Must-know: A bond investor’s guide to duration by Surbhi Jain.

To see how the recent recovery in global GDP is affecting bond yields, please see the next article in this series.

For additional analysis related to other key fixed income ETF tickers, please see the related Series, Fixed income ETFs: Short-duration alternatives for bonds.

Outlook: High credit quality and longer-duration (TLT & BND) versus lower credit quality and mid-duration (HYG & JNK)

For fixed income investors concerned with rising interest rates and falling bond prices, long-dated (long duration) ETFs such as the iShares 20+Year Treasury Bond ETF (TLT) may continue to see price declines if interest rates continue to rise. Note that the TLT ETF has a duration of approximately 16.35 years—roughly twice that of the current ten-year Treasury bond at 8.68 years. In contrast to the long-dated TLT, the iShares iBoxx High Yield Corporate Bond ETF, HYG, has a much shorter duration of only 3.98 years, as well as exposure to improving commercial credit markets, and may continue to outperform the long duration TLT ETF in a rising rate environment.

However, investors should note that the High Yield portfolio of HYG holds roughly 90% of its portfolio in bonds rated BBB3 through B3, with roughly 10% of its portfolio in CCC-rated credit (substantial risks). HYG top holding includes Sprint Corp (S) at 0.56% of the portfolio. The Vanguard Total Bond Market ETF (BND) maintains a duration of 5.5 years, though it holds 65.4% of its portfolio in government bonds and 21% of his holdings in AAA–A rated bonds. Compared to HYG and JNK, the BND ETF is slightly longer in duration (BND 5.5 years versus HYG 3.98 and JNK 4.20). But it’s very much concentrated in government and high-quality bonds, and will therefore be less impacted by changes in the overall commercial credit markets.

Lastly, for investors looking to maintain yield while gaining exposure to the commercial credit market, an alternative to the iShares HYG, the Barclays High Yield Bond Fund ETF (JNK), offers a similar duration of 4.20 years versus HYG’s 3.98 years, holding 84.17% of its portfolio in corporate industrial, 7.65% in corporate utility, and 7.5% in corporate finance-oriented bonds. Like HYG, even JNK is a big fan of Sprint (S), with its top holding of First Data Corporation (0.72%) followed by Sprint Corp. (0.62%), Sprint Communications (0.59%), and HCA Inc. (0.53%).

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