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ETF Specialist

Why Bonds Still Matter

Low yields and the potential for rising inflation notwithstanding, bonds are still valuable within a diversified portfolio.

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A version of this article previously appeared in the April 2021 issue of Morningstar ETFInvestor. Click here to download a complimentary copy.

Today’s bond market is characterized by low yields, tight credit spreads, and the potential for rising inflation. Value is difficult to find in bonds, but that doesn’t mean they don’t offer value in investors’ port­folios. Here, I review the current state of the bond market, detail why a core bond position is still valu­able, and spotlight a pair of bond exchange-traded funds that might add some value back to a core bond position.

Poor Prospects

Inflation fears have been at the forefront in recent months. As of mid-June 2021, the 10-year break-even inflation rate (a measure of the market’s inflation expectations) and the difference between 10-year and two-year Treasury rates (a measure of the steepness of the yield curve) soared to five-year highs, reaching 2.35% and 1.23%, respectively. The passage of The American Rescue Plan Act of 2021 and the quickening rate of coronavirus vaccine distribution have helped to increase market expectations for future inflation and growth.

Bond investors are rightfully concerned over the potential for a period of sustained rising inflation--a foreign prospect for many investors who have never lived through such an episode. The average monthly 10-year break-even inflation rate rose for eight consecu­tive months through June 2021. This was just the second time this happened since January 2003 (the first available date for the 10-year break-even inflation rate published by Federal Reserve Bank of St. Louis). This followed a stretch during which it increased for five consecutive months from April 2020 through August 2020.

Of course, more-experienced investors will recall periods marked by longer and more acute increases in inflation, which predate the introduction of Treasury Inflation-Protected Securities (and thus the 10-year break-even inflation rate). But applying lessons learned from those experiences to today might be a mistake, given the current level of interest rates. The effective federal-funds rate, the benchmark interest rate set by the Federal Reserve for overnight lending between banks, remained near an all-time low as of February 2021, at 0.08%. By comparison, the average monthly effective federal-funds rate during the 1970s--a decade marked by high and rising infla­tion--was 7.10%.

Inflation expectations can help explain the current slope of the yield curve, which was as steep as it has been in five years as of the end of March. Long-term yields have risen to reflect the expected rise in inflation, while short-term rates have remained rela­tively stable.

When bond investors hunt for value, they tend to zero in on credit risk to identify mispriced bonds. When the going gets tough and bond investors get scared, credit spreads widen and value is abundant. But today, as seen in Exhibit 1, spreads are historically tight. The graph depicts the 10-year constant maturity Trea­sury rate in blue and the option-adjusted spread, or OAS, for the ICE Bank of America U.S. Corporate Bond Index in red. The dotted lines represent the rolling 36-month averages for each.

Credit spreads widen when the market demands more compensation for bearing credit risk. Such episodes register as spikes in the solid red line in Exhibit 1 and have coincided with the bursting of the dot-com bubble, the global financial crisis, and the coronavirus crisis. Following each of these shocks, credit spreads tightened to their precrisis levels. Trea­sury yields fell consistently throughout the period, depicted by the downward trend of the blue lines.

At the end of March 2021, the OAS of the ICE Bank of America U.S. Corporate Bond Index was 1.01%, 60 basis points lower than its rolling 36-month average, intimating the market requires less compen­sation for bearing credit risk relative to its historic average. But Exhibit 1 also indicates there is a greater penalty for bearing credit risk, because of the increas­ingly sharp jolts to OAS that occurred in response to each of the three major market shocks. This is in part because falling interest rates provided an incen­tive for risk-taking, leading to sharper drawdowns when credit spreads widen.

The current combination of low yields, tight spreads, and expectations for rising inflation make bonds look awfully unappealing. But that’s not to say that a core bond strategy doesn’t have a role in your portfolio.

Bonds Are Ballast

Bonds are not preordained to diversify equity risk, so it should not be taken for granted that they always will. As seen in Exhibit 2, bonds’ correlation with stocks has fluctuated widely over time. The exhibit depicts the rolling 36-month correlation between the Bloomberg Barclays U.S. Aggregate Bond Index and the Russell 3000 Index, as well as the effective federal-funds rate.

Clearly, bonds have not always zigged when stocks have zagged. In fact, throughout most of the 1990s, a zag in the stock market led to a half-zag in the bond market. But that relationship changed preceding the dot-com crash of the early 2000s. There have been periods where the correlation between the two has spiked. These have coincided with equity market shocks and steep declines in interest rates. For instance, after the effective federal-funds rate was reduced by 5 percentage points following the global financial crisis of 2008, bonds’ correlation to the Russell 3000 Index increased dramatically. A similar jump in the correlation between the two was spurred by the coronavirus pandemic.

But a broadly diversified and conservative core bond position is still valuable. While bonds’ correlation with stocks has and will fluctuate with time, they have and will likely remain well below 1. And even in those moments where correlations spike, bonds will hold up better than stocks. The relative certainty of bonds’ cash flows and future value are what make high-quality bonds an effective diversifier of equity risk. This applies irrespective of the level of interest rates, credit spreads, or what the market’s inflation expectations might be.

But with the potential for rising inflation, a broadly conservative core bond fund could struggle to deliver investors’ desired return. The search for yield has been a motif since well before the global financial crisis. Falling interest rates have given investors incen­tive to court additional risks. Excessive risk-taking can lead to disaster, especially considering the current low levels of credit spreads. That said, there may be small pockets of value to be found in today’s bond market.

Adding Value

Several ETFs construct portfolios by identifying and overweighting undervalued bonds. But bonds with the highest potential value also tend to be riskier. Specifically, they tend to take on more credit risk and offer less diversification potential as a result. Striking a balance between value and quality is difficult.

One ETF that attempts to juggle value and quality is iShares Aaa-A Rated Corporate Bond ETF (QLTA). The fund tracks the Bloomberg Barclays U.S. Corporate Aaa-A Capped Index, which includes U.S.-dollar-denominated corporate bonds that are rated higher than BBB. Removing the lowest-rated investment-grade bonds leaves out half of the investment-grade corporate debt market, but these higher-rated bonds are less likely to be overvalued, as investors aren’t as apt to chase their relatively lower yields. Addition­ally, relative to the broader investment-grade market, QLTA is less correlated to the stock market.

Another ETF that focuses on top-rated issuers within its corner of the market that also more systematically seeks out values is VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL). The fund tracks the ICE U.S. Fallen Angel High Yield 10% Constrained Index. The benchmark comprises corporate bonds that were rated investment-grade when they were issued but were subsequently downgraded to junk status. The high-yield corporate bond market is extremely risky, but the fallen angel subset serves up values as a result of post-downgrade forced selling, which allows this fund to take advantage of the subsequent mean reversion in many of these bonds’ prices. ANGL is considerably riskier than QLTA, but both funds are less vulnerable to credit conditions relative to their category peers.

Neither QLTA nor ANGL is a cure-all for the issues plaguing the broader bond market, but both present compelling options for adding back some yield without sacrificing too much of the diversification potential delivered by a core bond offering.

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Neal Kosciulek does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.