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Bond Compass

Q1 ETF Playbook for Bond Investors

With rate cuts on the horizon, new challenges associated with reinvestment risk and rate volatility replace the rising rates and elevated volatility that defined a turbulent 2023 bond market.

10 min read
Matthew J Bartolini profile picture
Head of SPDR Americas Research

Reinvestment Risk and Rate Volatility to Challenge Bonds

Last year, US 10-year rates traded in a wider than normal range,1 moving as low as 3.3% in the early part of the year before rising to a high watermark of 5% in October. Rates then retreated and ended the year around 4%. Core bonds narrowly escaped registering their third consecutive year with negative returns, thanks to a Q4 policy pivot from the Federal Reserve (Fed). And, because the central bank’s path and pace for cuts are far from certain, implied rate volatility ended the year in the 92nd percentile.2

The shorter end of the curve benefited the most from last year’s rising rates, with short-term US Treasury Bill rates spiking to 23-year highs (5.5%).3 Those generationally high rates accelerated the buying of money market mutual funds ($1.1 trillion of new assets) and ultra-short-duration government bond ETFs ($40 billion of inflows).4

In the aftermath of 2023’s buying spree, we expect rate cuts in 2024 will:

  1. Lower the return potential on the trillions in ultra-short bonds due to reinvestment risk, or reinvesting current income streams at lower rates.
  2. Deliver lower income potential for the same or greater risk for core bonds due to ongoing high levels of volatility as Fed policy evolves.

Rate Cuts to Increase Reinvestment Risk, Lower Returns

Consensus estimates and forward looking futures pricing suggest five rate cuts in 2024, with the policy rate falling from 5.5% to 4% by yearend.5 The first rate cut expected in May 2024 could be as much as 50 basis points (bps).

With a historical 99% correlation between the federal funds rate and US 3-month Treasury Bill yields (T-bills),6 any rate reduction will likely have a one-to-one impact on T-bills. Given that the return on T-bills is only from the stated yield, the Fed’s actions will impact the return on T-bills and other ultra-short bonds by a possible 50 bps to start —and potentially by more as the year unfolds and this minimal duration risk asset class is forced to contend with the consequences of reinvestment risk.

Over the past 30 years, as the yield on T-bills began to adjust, so did subsequent 12-month returns. In fact, there is a 97% correlation between the two time series (Figure 1). And as rates fell precipitously in 2001, 2006, and 2019, returns over the next 12 months were below that of the stated yield in the current month — due to reinvestment risk.

This suggests subsequent returns over the next 12 months will be lower than last year’s 5.01%7 for the $1 trillion plowed into money market funds and similar duration exposures in 2023.

Positioning for Greater Short-term Returns

While the aggressive buying of $1 trillion of ultra-short bonds in 2023 was predicated on yield, it was also driven by the need for return stability.

Current strategies to help blend income generation with some stability (from both rates and fundamentals) include adopting a total return mindset and laddering further out on the short-to-intermediate duration curve. Notably, targeting quality helps avoid introducing any significant credit risks or fundamental instability.

Investors also can take on modest duration risks, tactically overweighting short to intermediate investment-grade corporate bonds with a maturity less than 10 years. Owning the following can ensure they are fairly compensated for the duration risk assumed:

  • Bonds with maturities between 1 and 3 years that lead to a weighted duration of 1.8 years but carry a yield in excess of 5%.8 That yield has less correlation (71% ) to the federal funds rate than do ultra-short bonds.9 That means that if the Fed does cut five times, all five cuts won’t be felt on a one-to-one basis in the yield.
  • Bonds with maturities between 1 and 10 years that lead to a weighted duration of 4 years. This allows investors to modestly lengthen duration even more versus ultra-short markets but also trim duration risk (and volatility) relative to broader core bonds — all with a yield north of 5%.10

Sitting in the short-plus belly portion of the curve allows 1- to 10-year maturity exposures to strike a better balance between yield, duration, and potential volatility from rate movements relative to other corporate bond and Treasury sectors (Figure 2). Versus broad bonds, this better compensates investors for taking on some duration risk to mitigate reinvestment risk.

Bond ETFs to Help Reduce Reinvestment Risk

To reduce the eroding impact of reinvestment risk on bond returns, consider an active short-term bond ETF that invests beyond traditional bond sectors while seeking to maximize the yield-per-unit duration of the portfolio. Active approaches also can buy a short duration bond/sector, like mortgages, that may be screened out under a strict maturity band requirement.

For an actively managed short-term bond ETF consider:

  • SPDR® DoubleLine® Short Duration Total Return Tactical ETF [STOT], an actively managed strategy that prudently combines traditional interest rate-sensitive sectors with non-traditional credit-sensitive sectors in a duration-controlled portfolio (between one and three years) to potentially create a high-quality, low-volatility income strategy. With this approach, STOT has beaten its benchmark and had top quartile returns within the Morningstar Short Term Bond peer category over the last one- two- and three-year time periods.11

For short to intermediate high quality corporate bond ETFs, consider:

Evolving Fed Policy to Spark Volatility

Over 2024, the Fed will try to pull off a delicate passing of the baton in its policy relay race — transitioning from hiking to holding to cutting rates, without causing harm to the markets or the economy. This evolution of policy has and will likely continue to stoke rate volatility and realized risks for core bonds.

Throughout 2023, realized 90-day volatility for the Bloomberg US Aggregate Bond Index (Agg) ranked above the 90th percentile every day, even after the Fed signaled rate cuts (Figure 3). Notably, Fed policy is evolving at a time when global growth, including for the US, is expected to slow below long-term averages (2.9% versus 3.5%).12 Leaving little room for error.

Credit’s asymmetric vital signs are also unnerving. After a 13% gain in 2023, high yield credit spreads tightened to 360 bps13 — 27% below the historical 20-year average, which is part of the reason why high yield bonds are currently trading with negative convexity.14 This asymmetry in forward-looking returns indicates greater downside probability than upside given that spread compression likely won’t be the major contributor it was in 2023 (66% of the return).15

This means positive returns, at best, are to come from more of the coupon than spread changes (a still healthy 6%, but below the double-digit returns from 2023).16 It also indicates that credit valuations are not overly attractive and skilled credit selection may extract more value than owning the broader high yield market.

Rating trends, however, have moderated, as the broader economic outlook is now forecasting just a slowdown, not a recession — contrary to what many expected in 2023. There are still more downgrades than upgrades in high yield issuers,17 but the trend isn’t worsening. Default rates are also not expected to increase meaningfully,18 and a lower rate environment should help improve free-cash-flow generation for firms that were teetering on that brink.

Active Strategies to Guide Portfolios Through Uncertainty

With the wide range of outcomes for bonds due to continued elevated implied rate volatility levels (92nd percentile) and unconstructive valuations, alongside uneven fundamental trends for credit, active core bond strategies may help guide bond portfolios through this uncertainty.

By combining traditional and non-traditional fixed income asset classes to maximize total return over a full market cycle, active sector allocation and security selection can help investors take advantage of income and total return opportunities, while also seeking to mitigate the credit and rate risks facing core markets. In 2023, almost 80% of core-plus managers beat their benchmarks.19 In fact, active core managers’ ability to outperform a benchmark is a longer-term trend (Figure 4).

That level of consistency suggests that the flexibility active core managers have may be a valuable cornerstone to portfolios amid uncertainty. Meanwhile, active strategies that take an even more non-traditional stance and use hedging strategies with derivatives to augment risks facing bonds may also allow for more tactical positioning amid shifting economic and fundamental trends.

That type of satellite mandate may help drive more opportunistic alpha opportunities by increasing flexibility at an uncertain time. And, more than 70% of non-traditional bond funds beat their benchmark by an average 120 bps in 2023.20

For an active core strategy that may help insulate your core bond portfolio from elevated volatility, while also pursuing total return opportunities, consider:

  • SPDR® DoubleLine® Total Return Tactical ETF [TOTL], an active core bond exposure that combines traditional and non-traditional fixed income asset classes. TOTL seeks to generate high-quality income by exploiting inefficiencies within the global fixed income market, while maintaining active risk constraints. The ETF’s approach has led to above benchmark performance over the past one, two, and three years.21

For an opportunistic bond fund that may be able to navigate market risks and tactically reposition toward alpha generating opportunities, consider:

  • SPDR® Loomis Sayles Opportunistic Bond ETF [OBND], an actively managed multi-asset credit strategy that may invest in any credit quality across all fixed income sectors, including bank loans and securitized credit instruments. OBND also may invest throughout the entire maturity curve, with a target portfolio duration between zero to seven years, while using derivatives to tactically adjust risk sensitivities and target mispricings. Since inception in 2021, OBND’s approach has led to 551 bps of cumulative outperformance over the Agg and a top quartile peer performance ranking for 2023.22

Positioning for a Dual Pivot

An evolving policy environment, where the Fed is likely to forcefully pivot from holding rates steady to cutting rates numerous times, requires rethinking what has worked well since the end of 2020 — when ultra-short-duration cash-like instruments beat broader bonds by a cumulative 16.2%.23

Tight credit spreads, slowing growth, elevated rate volatility, and geopolitical tension tail risks add to the challenges for bond investors. In 2024, being selective in shorter duration markets to navigate reinvestment risks and adopting a flexible total return mindset in the core to temper the impact of overall volatility may help position bond portfolios for pivots in, both, rates and past performance leaders.

In all markets, bond ETFs — with their liquidity, transparency, and low costs — can help investors generate income, preserve capital, and manage risks. Stay up-to-date with fresh insight and education as Fed policy evolves.

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