With the Federal Reserve once again in an “interest rate-cutting” mood, some bond investors are making fantastic returns in 2019. Several bond ETFs are beating the S&P 500 year-to-date, despite the popular index increasing by more than 20% thus far in 2019.
Perhaps you are wondering how boring old bonds could be beating top growth and technology stocks in 2019?
Well, the answer is simple; when interest rates fall, long term bonds that have higher “nearly guaranteed” yields become more valuable. If current 10-year Treasury yields are around 1.75%, but you own an older 10-year Treasury bond that is yielding say 3.0%, investors who are looking for safe, reliable yields, will be willing to pay a nice premium for your older 10-year Treasury bond.
Funds such as the Vanguard Long-Term Corporate Bond ETF (VCLT), the Vanguard Extended Duration Treasury ETF (EDV), and the iShares 20+ Year Treasury Bond ETF (TLT) are all increasing in value as interest rates decline. Year to date, these three ETFs are up 21.37%, 25.01%, and 18.36% respectively, all without using any sort of leverage.
The three bond ETFs mentioned above are all increasing in value while current interest rates fall. However, these three funds and many others like them will do the opposite when interest rates begin to climb higher. But, since the Federal Reserve and other central banks around the world are in rate-cutting mode, investors can reasonably expect rates to stay at their depressed states for some time, if not go even lower.
That is where current investors, who may have missed out on the bond rally, can perhaps still get in on the party and reap the rewards. If the Fed decides interest rates are not low enough in the coming months and again cuts rates, certain bond funds will continue to increase in value.
After cutting rates in September, Fed Chairman Powell said, “If the economy does turn down, then a more extensive sequence of rate cuts will be appropriate.” How high the long-term bond funds will increase will be based on how low current interest rates fall.
Furthermore, these bond funds all typically pay a decent yield to an investor who wants to own the fund and wait and see what happens. VCLT pays a 3.5% yield to maturity with an expense ratio of just 0.07%. EDV has a yield to maturity of 2.0% while also only charging 0.07% expense ratio. TLT has an expense ratio of 0.15% but offers a yield to maturity of 2.49%.
One of the best performing non-leveraged bond ETFs of 2019 is the Pimco 25+ Year Zero Coupon US Treasury Index ETF (ZROZ) which is up more than 27% year-to-date. ZROZ also has a nice yield to maturity of 2.12%, despite the fund owning bonds that don’t pay a yearly coupon. Just like EDV, these funds own Treasury bonds that promise one single payment upon maturity, not annual payments like traditional bonds. This makes them very sensitive to rising interest rates and inflation but boosts their returns more than other bonds when rates fall.
Despite not being paid a yearly coupon payment, these funds still pay yields to investors because of the proceeds made when the funds are re-balanced. Therefore, these yields, just like the price of the funds, can vary wildly. If the fund is increasing in value, they will also likely follow suit. But when the funds begin to decline, because interest rates are creeping higher, the yield may be cut.
Since the Fed just recently cut rates, investors would assume that rates aren’t going to run higher in the short term, making an investment in one of the mentioned funds relatively safe today. But, remember there is risk involved with owning these bond ETFs. Powell also noted in his most recent press conference that he does not foresee a recession and that economic growth should continue at a steady pace, despite trade headwinds. If he is correct, further rates cuts will not be necessary and jumping in these bond ETFs will turn out to be a poor investment since they will lose value when interest rates rise.
Disclosure: This contributor did not own shares of any asset mentioned above at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.