Source: CapitalCube ETFs
Why Are Bond Yields Down This Year, and Where are They Headed?
Despite a contraction in the first quarter, the consensus outlook for the U.S. economy is still bright. It is therefore somewhat puzzling that interest rates have not drifted higher as most economists predicted. The yield on 10-year Treasuries started the year at around 2.8% and the consensus view called for rates to drift to 3% or higher by the end of the year. In fact, just the opposite has occurred, and the yield on the 10-year fell to a low of 2.44% in late May before rebounding to 2.63% as of June 10.
So what is driving interest rates? There are three main factors that have pushed bond yields lower this year:
- Policy uncertainty – The Fed laid out a plan for ending quantitative easing this year and raising short-term rates based on economic conditions (most economists expect a short-term hike sometime in 2015). In the meantime, the U.S. economy contracted at an annual rate of 1.0% in Q1 2014, and April data suggest a slow start to Q2 as well. Recent trends have caused economists to dramatically lower their growth forecasts and question Fed policy. To some extent, the change in sentiment has stemmed the rush of investment flows out of Treasuries as occurred during the “Taper Tantrum” in mid-2013.
- Geopolitical instability – The Ukraine-Russia conflict has raised the probability that the fragile economic recovery in Europe will lose steam. Additionally, oil prices remain above $100 for multiple reasons, and concerns over China’s growth and the health of its banking sector have raised fears of a weak global economy.
- Bond Valuations – Given the low inflation and slow growth environment in the U.S. and most developed countries, U.S. bond yields are relatively high on a comparative basis. For example, German 10-year Bunds are yielding just 1.38%, and Japanese 10-year JGBs are at a mere 0.58%. Bond yields have also fallen dramatically in the Euro-periphery countries, making U.S. Treasuries look cheap with a yield of 2.6% give or take a few tenths of a percent.
While these are not necessarily flash-in-the-pan market forces, the consensus view remains that rates must go up eventually. The consensus is almost certainty correct, but the timing remains uncertain, which has led to some sharp disagreements between investment powerhouses like Pimco and Goldman Sachs. So, what does this mean for the bond market going forward? If the consensus view is right (which I think it is), there could still be some ways to incorporate fixed income into your portfolio. In the current environment, I like floating rate bond funds because they provide higher yields than a money market while also protecting against interest rate risk. Here are two noteworthy floating rate bond ETFs: FLOT and FLRN.
iShares Floating Rate Bond ETF (NYSE: FLOT)
This fund provides exposure to U.S. floating rate bonds whose interest payments adjust to reflect changes in interest rates (up or down). FLOT tends to invest in shorter-term investment grade bonds and holds 300+ securities. The largest holdings include bond issuances from JPMorgan Chase, GE Capital, Goldman Sachs, Citigroup, and the Royal Bank of Canada.
FLOT has an expense ratio of 0.2%, which is about average compared to its peers, but it has underperformed fixed rate bond funds so far this year. From 1 year ago, FLOT is up just 0.77% compared to its benchmark index’s (the Barclays Capital US Floating Rate Note <5 Years Index) performance of 0.99%. Floating rate bonds tend to fluctuate in value less than their fixed-rate counterparts. A fund like FLOT could therefore be a way to insulate against inflation – which may not be an immediate threat, but many economists expect a substantial rise in economic growth, inflation, and interest rates at some point over the next 1-2 years.
SPDR Barclays Investment Grade Floating Rate ETF (NYSE: FLRN)
FLRN is very similar to FLOT. This fund also tracks the Barclays U.S. Dollar Floating Rate Note < 5 Years Index, however FLRN has underperformed FLOT and has experienced much higher volatility (see tables below). On the plus side, its lower expense ratio (just 0.15%) which gives the fund an advantage on total return if you are focused on short-term results.