What a Difference A Year Makes For Bond ETFs

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The bond markets are now entering a new era of price and yield discovery that will be driven by traditional supply and demand forces rather than government stimulus. The end of the third round of quantitative easing by the Federal Reserve is seen by many to be a positive sign of economic stability. However, others wonder if it will mark a turning point in equity and fixed-income dynamics until the next interest rate tightening phase takes center stage.

No matter what the eventual outcome, it’s safe to say that 2014 has marked a significant change in investor appetite for risk in the bond market. Last year, the hot places to be were high yield, convertible bonds, and senior floating rate notes as these credit-sensitive areas were considered attractive in a rising interest rate environment. Now the balance of power has shifted to treasury, investment grade, and high quality mortgage debt as the primary leaders in each category.

The following table illustrates the returns for each category using ETFs for both 2013 and 2014 YTD:

*Data as of 11/3/14, source: stockcharts.com

The most lackluster returns this year have from senior loans, which are typically most coveted when bond yields are rising. The PowerShares Senior Loan Portfolio (BKLN) was considered a strong candidate to replace traditional fixed-income allocations in 2013 because of its ability to side step interest rate risk. However, the lack of demand for high yield credit has stifled gains in floating rate bank loans this year as investors have sought to capitalize on intermediate and long-term fixed-income.

Another sector that has seen a marked shift in volatility has been junk bonds. The iShares High Yield Corporate Bond ETF (HYG) has slowed its ascent in recent months and provided some cause for concern over uncertain price action. Many experts believe that high yield bonds have shown signs of over exuberance in recent years as investors have sought lower credit quality holdings to keep pace with yield expectations.

Not surprisingly, this shift has coincided with a marked retracement in bond yields as a result of investors rebalancing their risk exposure to include safe haven assets. On a year-to-date basis the CBOE 10-Year Treasury Note Yield (TNX) has fallen from a high of 3.00% to a current level of 2.4%. This 22% decline speaks volumes about the shift in sentiment and trends to reduce exposure to credit-focused sectors in favor of interest rate driven assets.

A beneficiary of this falling interest rate environment has been ultra-long duration treasuries as evidenced in the 31% return of the Vanguard Extended Duration Treasury ETF (EDV) in 2014. This ETF tracks an index of extended-duration zero-coupon U.S. Treasury securities with an average effective maturity of 25.3 years. EDV and similar exchange-traded funds in this category provide a true directional bet on interest rates, which can be a double edged sword.

The strength in investment grade corporate bonds such as the iShares Investment Grade Corporate Bond ETF (LQD) and Vanguard Long Term Corporate Bond ETF (VCLT) serve as a confirming indicator that quality debt is still in high demand.

How long this current trend will last is a topic that is certainly up for debate and will likely be driven by economic data and further guidance from the Federal Reserve on interest rate policy. In addition, don’t underestimate the dynamics of fear and greed cycles in the stock market that can have a spillover effect to bonds. The return of volatility and distress in October marked an extreme for bonds this year that will be a closely watched price level moving forward.

For the moment, fixed-income investors appear to be betting on interest rates staying low for a prolonged time frame. However, it pays to be nimble and mindful of the risks that conditions can change rapidly at the intersection of duration and credit quality.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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