Bond ETFs hit their lowest levels of the year last Thursday as interest rates surged. The benchmark US 10-year Treasury note yield jumped as high as 4.33%, eclipsing its 4.24% peak from 2022 and reaching its loftiest level since 2007.
The yield on the five-year US Treasury note also hit a 16-year high at 4.47% last Thursday while the yield on the 30-year Treasury bond climbed to a 12-year high at 4.42%.
As yields spiralled higher, bond ETFs that track US Treasuries slid (bond prices and yields move inversely).
The iShares 20+ Year Treasury Bond ETF (TLT) – this year’s second most popular ETF by inflows – is now down nearly 5% year to date.
The iShares 7-10 Year Treasury Bond ETF (IEF) also hit a new low for the year and is now down by 1.2%.
Higher for longer
The recent upside acceleration in market-based interest rates comes despite expectations that the Fed is likely finished hiking rates. Probabilities based on the pricing of fed funds futures suggest there is a 58% chance the fed funds rate ends the year where it is now.
Still, just because the Fed might be done hiking the fed funds rate – a benchmark for short-term interest rates – does not mean other interest rates are done going up.
After all, the yield curve is still inverted; the 10-year Treasury yield is currently around 100 basis points below the fed funds rate.
If investors start to believe the Fed might hold the fed funds rate at its peak level for a while, it makes sense for them to start pricing that into longer-term interest rates.
This “higher for longer” idea is one espoused by the Fed itself, but it has been buttressed by recent strong economic data.
A model from the Federal Reserve Bank of Atlanta estimates that US gross domestic product in the third quarter could be growing at a 5.8% annualised rate – well above what the Fed or most economists have been expecting.
Such strong growth is welcome on the one hand but it also introduces the risk of inflation picking up again.
To push back against that risk, the Fed is likely to maintain a hawkish bias in its monetary policy.
Bond ETFs getting hit
US Treasury bond ETFs are not the only funds getting hit by the “higher for longer” narrative. The iShares iBoxx $ Inv Grade Corporate Bond ETF (LQD) has nearly wiped out all of its gains for the year.
The two biggest bond ETFs, the iShares Core US Aggregate Bond ETF (AGG) and the Vanguard Total Bond Market Index Fund ETF (BND) have also given up their gains.
AGG and BND hold a combination of various types of investment-grade bonds, including Treasuries, mortgage-backed securities and corporate bonds.
One bond ETF that is holding up better than others is the iShares iBoxx $ High Yield Corporate Bond ETF (HYG). The junk bond fund is still sporting a gain of more than 4% for the year.
Stronger economic growth means the issuers of high-yield bonds are less likely to default, which is good news for the holders of those bonds.
Still, if rates keep surging, at some point that will likely weigh on junk bonds as well.
This article was originally published on ETF.com
