This shift has left bond investors wondering what the rest of the year looks like for bond returns. Can fixed income recover its losses this year and end in the black? It’s not likely for traditional core bond portfolios, by which we mean those strategies represented by the widely-referenced broad benchmark Barclays US Aggregate Bond Index (AGG) that invest heavily in interest rate-sensitive government-related bonds.
Market Realist – Where’s the relative value within fixed income?
The graph above compares the year-to-date returns on four bond ETFs. Except for high yield bonds (HYG), all these ETFs have given negative returns. AGG has dropped by 0.8%, while the iShares Barclays 20+ Year Treasury Bond ETF (TLT) has dipped by 6.4%. TLT tracks the performance of the highly sensitive long-dated Treasuries. The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) has eroded investor wealth by 2.0% year-to-date.
When interest rates rise, credit markets and the economy usually improve, so bonds with more credit risk tend to outperform bonds with less credit risk. So high yield bonds (JNK) are likely to outperform investment-grade bonds, which in turn are likely to outperform Treasuries.
During the last period of rising rates, from December 2008 through June 2009, yields on ten-year US Treasuries increased from 2.08% to 3.95%. Credit spreads also tightened, with investment-grade spreads declining from 5.9% to 3.2% and high yield spreads declining from 19.0% to 9.2%.
The returns for the iShares Barclays 7–10 Year Treasury Bond ETF (IEF), LQD, and the SPDR Barclays Capital High Yield Bond ETF (JNK) between December 2008 and June 2009 were -10.2%, 0.7%, and 32.3%, respectively.
While higher interest rates have proven to be a headwind for stocks and investment-grade bonds, high yield bonds have done relatively well year-to-date and over the last period of rising rates. High yield bonds appear relatively attractive.