Bonds: Total Market
In 2023, yields started where they ended, although there was considerable volatility in between. Notably, yields dropped sharply following the collapse of Silicon Valley Bank in the spring amid concerns that it would spark a greater crisis. And, yields spiked in autumn with the 10-year Treasury yield exceeding 5% following an uptick in inflation.
In hindsight, this marked the bottom for fixed income as the Bloomberg U.S. Aggregate Index gained nearly 10% between the end of October and the new year. Looking ahead, Vanguard believes this strong performance will continue in 2024.
In terms of its outlook, it sees inflation ending the year just above the Fed’s 2% target. It believes the Fed will ease policy, although they don’t see rates returning to the same lows as the previous cycle. It also sees the yield curve steepening as short-term rates fall further.
The firm also acknowledges some risks to its outlook such as the economy continuing to be bumpy even within the context of a slowdown which could lead to false signals. Credit spreads have remained tight which means that there is greater risk in the event of a recession. High deficits mean that Treasury supply will be plentiful, adding upwards pressure to yields. Finally, inflation could re-ignite especially given geopolitical risks and prevent the Fed from easing even if the economy warranted it.
Finsum: Many active fixed income funds are being launched with a specialized focus on a particular niche. These funds have outperformed amid the volatility in the fixed income market.
For income-seeking investors, navigating the often volatile capital markets can be a tightrope walk between yield and stability. Enter income-producing ETFs, a potent blend of diversification and dependable returns. These innovative funds package high-yielding assets into a single, tradable security, offering investors a steady income stream without the burden of individual security selection.
One of the key strengths of income-producing ETFs lies in their inherent diversification. By spreading investments across a basket of assets, they mitigate the risks associated with individual maturities or underperformance. This eliminates the headache of reinvesting maturing bonds at potentially lower rates, a common pitfall for fixed-income investors.
Furthermore, income-producing ETFs typically hold less cash than their mutual fund counterparts. This seemingly minor distinction translates to a potentially significant advantage: reduced cash drag. Unlike mutual funds, which often require a cash cushion to facilitate redemptions, ETFs minimize uninvested capital, ensuring a greater portion of your portfolio actively generates income within its intended asset class.
Financial advisors seeking to craft reliable income streams for their clients should consider income-producing ETFs as a possible solution. They provide instant diversification, mitigate reinvestment risk, and maximize income potential through reduced cash drag.
Finsum: Income-producing ETFs can provide both diversification and steady returns with reduced reinvestment risk and cash drag.
The era of high yields has led to a significant boost of inflows into fixed income ETFs. Last year, short duration bond ETFs were the biggest recipient of inflows, but this started to change at the end of last year. Inflation started to move closer to the Fed’s 2% target, and the market began to price in rate cuts in 2024.
So, investors have been moving further out in the curve into intermediate and longer-duration fixed income ETFs to lock in yields for a longer period of time. One example of this can be seen in BondBloxx ETFs.
For instance, the BondBloxx Bloomberg Ten Year Target Duration US Treasury ETF has seen $49 million of inflows YTD. This is more than 50% of net inflows over all of last year. In contrast, the BondBloxx Bloomberg Six Month Target Duration US Treasury ETF only has $17 million of net inflows YTD, while it had $904 million of inflows last year.
BondBloxx has also seen similar flows from its 1 Year and 2 Year duration-focused Treasury ETFs. To appeal to fixed income investors seeking longer duration exposure, the firm recently launched 3 high-yield corporate bond ETFs with time frames of 1-5 years, 5-10 years, and more than 10 years.
Finsum: Flows into fixed income ETFs remain strong in 2024, but one definite change is that investors are favoring intermediate and longer-duration ETFs in anticipation of the Fed cutting rates.
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Stocks were lower, while Treasuries caught a bid following the latest FOMC meeting which was deemed hawkish despite the Fed holding rates as expected. In essence, Chair Powell’s remarks during the press conference made it clear that the central bank is not willing to cut yet.
In response, markets were in a risk-off mood. Fed futures showed that the odds of a rate cut at the next meeting declined from 40% to 36%, while the odds of the first cut happening in May increased to 59% from 54%.
Overall, the policy statement and Powell’s press conference underscored that the Fed is moving in a more dovish direction, just not as fast as the market’s desired pace. The policy statement expressed that there is a better balance in terms of employment and inflation goals. However, before cutting rates, it wants to see even more progress on the inflation front. In essence, the resilient economy and labor market mean that the Fed has more latitude to continue its battle against inflation before pivoting to support the economy and risk re-igniting inflationary pressures.
Rather than hawkish or dovish, its current stance can be characterized as ‘data-dependent’. Some of the important releases, prior to the March FOMC meeting, will be the January and February employment data and consumer price indexes.
Finsum: The Fed held rates steady but came out slightly more hawkish than expected. This led to the odds of a rate cut in March slightly dropping, but the bigger takeaway is that the Fed sees inflation and employment risks as being balanced and remains data dependent.
In 2024, the major market narrative has certainly shifted from whether the Fed will cut or hike to when and how much the Fed will cut. According to Steve Laipply, BlackRock’s Global Co-Head of Bond ETFs, it’s a good time to lock in yields. Currently, investors can achieve yields of 4% in low-risk, diversified bond funds which is quite attractive relative to recent history.
During the previous cycle, investors would have to buy riskier high-yield bonds to achieve such income. Overall, he believes that investors have been overly risk averse during this tightening cycle, and most are underexposed to the asset class. Despite the recent rally, there are plenty of opportunities to capture generous yields with lower levels of risk. Further, fixed income would benefit if the economy weakened further, and inflation continues to lose steam.
While investors can get even higher yields in the front-end of the curve or with certificates of deposit, Laipply doesn’t see this as a prudent approach given underlying macroeconomic trends, and the Fed’s dovish tilt in the new year. He recommends that investors choose a diversified, broad bond fund like the iShares Core US Aggregate Bond ETF or an active fund like the Blackrock Flexible Income Fund.
Finsum: According to Steve Laipply, Blackrock’s Global Co-head of Bond ETFs, investors should lock in yields given the rising chance of a recession, slowing inflation, and a dovish Fed in 2024.
Currently, fixed income investors can lock in yields that are in-line with the average, historical return in equity markets. According to David Leduc, the CEO, Insight Investment North America, this is a major reason we are in a new ‘golden age’ for bonds.
Another reason to be bullish on the asset class is that most funds are deployed via passive strategies. This has increased liquidity and decreased transaction costs, while also leading to more inefficiencies which astute active managers can capitalize upon.
Leduc believes that fixed income benchmarks are inherently flawed given that indexes are weighted based on debt issuance. The end result is that passive fixed income investors are overexposed to the most indebted companies.
In contrast, active managers can achieve alpha through careful selection in terms of value, credit quality, and duration. While passive funds invest in a relatively small slice of the fixed income universe, active managers have much more latitude in terms of securities to better optimize portfolios in terms of risk and return. One constraint for active managers is that some strategies are successful but can’t necessarily be scaled. Many err by simply sticking to duration positioning which increases near-term volatility.
Finsum: It’s a golden age for fixed income with bonds offering equity-like returns. Here’s why investors should favor active strategies especially as the risk of a recession grows.