The Federal Reserve's latest minutes should give investors pause for thought afte the central bank warned about the ongoing risk of inflation.
Investors best not ignore three words from the report, which covered the goings-on at the Fed’s June meeting that featured the central bank's first rate pause since early 2022.
A critical section of the announcement for ETF investors was the committee’s belief that there were “few clear signs” that inflation is on a path to declining toward its 2% target rate anytime soon.
That opens the door for potentially higher interest rates, at a time when the economy may still not have fully reacted to the series of hikes already delivered.
ETFs offer investors a chance to target their exposure more earnestly to all types of bonds, especially those that flirt with high levels of “credit” risk. Simply put, for any corporation that has relied on cheap financing over the past decade, the prospect of higher rates is daunting.
As investors found out in 2022, bonds can lose money too. Therefore, fund selectors should recognise that while clients have come to expect stock market volatility, seeing their bond holdings collapse can be more unexpected, prompting more proactive communication.
Bond ETFs
Taken together, the three ETFs described below can help advisors create a picture of today’s bond market, its reward potential and its risks. History is littered with wealth destruction that stemmed from “reaching for yield” during a rising rate cycle. This is the investing equivalent of taking too much candy out of the candy jar. It satisfies, but then you get very ill.
The startling rise in yields for very short-term US Treasury bills and notes might be temporary. So, an ETF like the iShares $ Treasury Bond 3-7yr UCITS ETF (CBU7) is a good baseline for a conversation about risk and reward in the world of bonds.
CBU7, which launched in 2009, captures the total return of the medium-term US Treasuries so there is minimal perceived risk of default, recent Congressional debt ceiling drama notwithstanding. CBU7's current weighted average yield to maturity is 4.4%, a decent proxy for the noncredit-bond space.
One step beyond is the iShares $ Corp Bond UCITS ETF (LQDE), which adds some credit risk by investing in corporate bonds, of which 45.7% are rated BBB. That is the lowest investment grade rating, and investors demand compensation for that risk.
LQDE has an average maturity of 13.2 years, so the bonds it holds are subject to that credit risk for a while. LQD yields 5.6% so investors must gauge the trade-off with something like CBU7 here.
In other words, clients are being adequately rewarded for stretching out in maturity and accepting much lower credit quality than US Treasuries. At the current yield “spread” of around 1.5%, that is a dicey call.
The next step down the credit quality scale is captured via ETFs such as the iShares $ High Yield Corp Bond UCITS ETF (SHYU), which invests mostly in bonds with a rating of BB or B, the heart of the “junk” category, with an average maturity of just under five years.
SHYU takes what LQDE does, and as iconic chef Emeril Lagasse would say, kicks it up another notch. Its current yield to maturity of 8% is more than 3% above LQDE’s, and nearly 5% higher than CBU7’s.
With the Fed’s signal that “few clear signs” exist to see an end to the upside risk to bond yields, and therefore potential bond price declines, there has perhaps never been a better time for investors to have a pivotal discussion about the trade-offs and workings of that other side of their stock market portfolio: bonds.
This article was originally published on ETF.com
