Turbulent conditions in both equity and bond markets are causing some advisors and their clients to re-think long-held, entrenched opinions about bonds.
The first long-held belief is that bonds are a portfolio’s defensive hedge when stock prices fall. While this theory held up in previous eras, the price action in 2022 has thoroughly disproved it.
Broadly diversified funds like the $77 billion iShares Core U.S. Aggregate Bond ETF (AGG) have collapsed right alongside equity funds tied to the Dow Jones Industrial Average, S&P 500, and Nasdaq-100.
Through the October 11th market close, AGG has declined around 15% in value since the start of the year. That compares to year-to-date losses between 18% to 34% for ETFs tied to the previous mentioned equity yardsticks. The bond and equity market have been highly correlated during this particular bear market.
The second entrenched viewpoint is that a broadly diversified approach to bond investing is always the safest bet. Like the first theory, this one has been proven wrong. How?
Aggressive interest rate hikes by the Federal Reserve has crushed diversified all market bond ETFs like AGG and its peers. Furthermore, diversification hasn’t prevented bonds held within these portfolios from sharp declines. Behind the gut-punch is skyrocketing interest rates, which are the most rapid since the 1980s. Moreover, the Fed has lifted rates by 0.75% at its past three meetings and they’re still not done. Looking ahead to its November meeting, more rate increases are likely.
Now let’s examine alternative bond ETF strategies that can help advisors to navigate the challenging environment.
Federated Hermes Short Duration Corporate ETF (FCSH)
Investing in bonds with long-dated maturities of 10-plus years is the last place bond investors want to be parked when interest rates are rapidly climbing. FSCH avoids this pitfall.
The fund’s portfolio has an effective duration that will generally be between 1.5 and 3.5 years. This strategy has saved FCSH from suffering the steep losses experienced by ETFs holding long-term bonds. Additionally, FCSH owns top-quality investment grade corporate debt. This is particularly important for risk adverse types. If credit conditions deteriorate, owning quality bond issues will matter.
Vanguard Short-Term Inflation-Protected Securities ETF (VTIP)
With inflation still running hot, it makes sense to consider inflation-hedged funds.
VTIP contains inflation-protected U.S. Treasuries that have a remaining maturity of less than five years. Due to shorter durations, the fund can be expected to have less interest rate risk compared to longer-duration TIPS funds.
The principal of TIPS fluctuates with inflation and deflation. While the interest rate of these securities is fixed, the amount of interest you get every six months may vary based on any change in the principal. Those changes are tied to the U.S. Consumer Price Index also known as the “CPI.”