Why are investors turning to bond ETFs?

Investors in Europe have invested $4.2 billion in bond ETFs in the past three months

Investors in Europe have piled into longer-duration U.S. Treasuries and higher-quality corporate debt ETFs, even as doubts linger over the stubbornness of high inflation and the response of the Federal Reserve.

According to data from Bloomberg Intelligence, bond ETFs in Europe have raked in more than $4.2 billion in the last three months, as at the end of July, at the expense of equity and commodity ETFs which saw outflows of 2 .5 billion and 5.5 billion, respectively, during the same period.

Much of this has occurred as part of a rotation from short-dated US Treasury ETFs to those closer to the midpoint of the yield curve.

As proof, the iShares $ Treasury Bond 7-10yr UCITS (IBTM) ETF added $1.6 billion in the last two months, to August 9, while investors withdrew $595 million from the iShares. $ Treasury Bond 1-3yr UCITS ETF (IBTS), according to data from ETFLogic.

At first glance, this change makes sense. After the Fed implemented two back-to-back interest rate hikes of 75 basis points (bps) – its highest level in 28 years – the second was quickly followed by the announcement that the United States had entered in technical recession.

In its July Global Macro Brief, JP Morgan suggested that “bad data is starting to look like good” as the economic slowdown may lead to a more moderate Fed, continued moderation in bond yields and a stabilization in the US. inflation.

If the market is to believe that the aggressiveness of the Fed so far in 2022 will end after the United States enters recession and inflation is brought under control, the past fortnight would suggest that this is how the events unfold.

While the two-year U.S. Treasury yield was down from its June highs, on Wednesday it was 21 basis points higher — at 3.21% — than it was when the Federal Treasury Committee open market (FOMC) concluded its meeting on July 27th.

Meanwhile, 10-year US Treasury yields have remained broadly flat at 2.79% so far in August, meaning we are in negative yield curve territory, a favorite indicator of recession.

In addition, consumer price inflation in the United States rose to 8.5% on Wednesday, below 9.1% for the previous month and 0.2 percentage points below economists’ forecasts.

Against a backdrop of strengthening recession signals and the potential onset of an inflation slowdown, one could not blame investors for feeling comfortable with the “soft landing” narrative and the idea that shorter-duration US Treasury yields – and their greater interest rate sensitivity – would become less attractive as most signs point to a less hawkish Fed.

However, others, like James Athey, chief investment officer at abrdn, warned that investors should avoid becoming complacent in the face of a more dovish Fed and an inverted yield curve.

A steeper yield curve, weaker US dollar and stronger risk assets are the obvious response to such an interpretation,” he warned. “The problem is of course that these market moves are acting to further ease financial conditions at a time when inflation remains at a 40-year high. This is not the outcome anyone in the Eccles building should have expected. wish to see.

BlackRock’s recent weekly market commentary also took a bearish tone, arguing that a “soft landing” is not a likely outcome in a volatile macro backdrop shaped by construction constraints.

“Central banks will have to plunge the economy into a deep recession if they are serious about crushing current inflation – or living with more inflation,” BlackRock said. “We think they’ll eventually do the latter – but they’re not ready to pivot yet. As a result, we expect weaker growth and high inflation ahead. »

Corporate bond ETFs in demand

Instead of making bets along the US Treasury yield curve, the world’s largest asset manager has offered support for investment-grade credit for reasons such as the number of defaults in 2022 being at its highest. low since 2014 and relatively low supply, with investment-grade issuance down nearly 20% from a year ago, according to data from S&P Global.

BlackRock also favored higher quality credit over US Treasuries as credit spreads remain wider than they were at the start of the year. Against equities, he said higher coupon income could provide a cushion against a further surge in yields following persistent inflation, while equity valuations currently do not reflect the possibility of slowing growth. .

Many investors are also buying into this narrative, with $1.6 billion poured into the $7.9 billion iShares $ Corp Bond UCITS ETF (LQDE) over the past two months.

Regardless of which side of the inflation and monetary policy fence investors sit on, it’s clear that bond ETFs have been the tool of choice for navigating the current market volatility.

In the current yield environment, Jordan Sriharan, fund manager at Canada Life Asset Management, said ETF feeds: “For investors looking for yield or income, there is less reason to fish for higher risk stocks or alternatives to achieve this.

“They can rebalance a portfolio more defensively or more typically, in line with the expected risk or volatility profile for their portfolio, back to bonds.

Sriharan said diversification is an obvious tool at this stage of the cycle, especially after many investors have decided to add more equity risk to their portfolios.

“The reality today is that credit, both investment grade and high yield, now trades at relatively more attractive yields and, therefore, is now an ‘alternative’,” he concluded. .

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