Improving economic conditions are a negative for the bond market
As improved economic conditions result in increased interest rates, bonds as an asset class lose their attraction. (Improved economic conditions simply mean the country as a whole is better off.) Central banks maintain low interest rates during tough times to give rise to consumption and investments. If rates remain low even after the economy improves, they will give rise to inflation. So interest rates rise as the economy grows. The rise in interest rates results in a fall in bond prices, as prices and interest rates share an inverse relationship.
Although the Fed has reduced its bond buying program from the original $85 million to $75 million in January 2014, to $65 million in February 2014, and to $55 million in April 2014, as per the latest announcement (signaling an improving economy), the bond market was spared a hard landing due to the volatile external environment and subdued indicators due to extreme weather conditions during the early part of the year. We can also see this trend in the broad-based Vanguard Total Bond Market ETF (BND), which invests in over 3,000 investment-grade bonds, including Treasuries. It has lost just $22 million and has been the 25th worst-performing fund over the last month.
Instead, the more restrictive iShares 1-3 Year Treasury Bond ETF (SHY), which invests in short-term U.S. Treasury bonds with remaining maturities between one and three years, has taken the hit, losing $160 million over the past month, as the yields for these maturities have seen the highest increase in the yields across maturities during the same period.
The SPDR Barclays High Yield Bond (JNK) has seen an outflow of $257 million despite improvements in credit risk profile, as the improvement in credit risk profile has been offset by the rise in yields on corresponding Treasury securities. The yield on high yield bonds is quoted as the yield on corresponding Treasury securities plus the credit risk premium. The SPDR Barclays High Yield Bond (JNK) invests in bonds issued by companies like HCA Inc. (HCA) and First Data Corporation, which is owned by KKR & Co. L.P. (KKR).
To find out more about the outlook for equity ETFs and fixed income ETFs in 2014, read on to Part 7 of this series.