Is It Finally Safe To Invest In Bond ETFs Now? (2024)

As we all know by now, since January of 2022 rising interest rates have devastated bond funds and ETFs. The chart below shows you how Vanguard's most popular bond ETFs have performed since January of 2022, which is when the Federal Funds rate began to rise from .08% to its current level of 5.33%.

Total (BND), Intermediate (BIV), Corp. Intermediate (VCIT), Short (BSV) and Ultra-Short (VUSB) ETF Total Return Since January 2022

Bond Prices Declined As Expected When Yields Climbed

Bond fund share prices declined because bond prices move the opposite way from bond yields. This has been known for years but after decades where any rise in bond rates lasted only a very short time and inflation a negligible factor a generation of investors has grown up who had never seen any but the smallest declines in bond fund and ETF NAVS.

Now that the Fed has paused its rate increases the question is arising more frequently of whether it is now, once again safe to invest in Bond ETFs without the risk of seeing double digit NAV losses.

Answering this is difficult because though we did see bond NAVs decline sharply as rates increased, they did not do so in a predictable way. In the following discussion I will focus on a range of Vanguard bond ETFs, but the conclusions we can draw from them will also apply to bond ETFs offered by other ETF providers like Blackrock and Fidelity.

Bond ETF Prices Have Not Declined to the Extent As Knowledgeable Investors Might Have Expected

Years ago when bonds were slowly declining from the highs of the early 1980s the rule of thumb we retail investors were taught was that the degree to which bond prices will move should correspond to a metric, Duration. Duration is a metric that is measured in "Years" though it does not necessarily correspond to the years to maturity of the bonds held by an ETF.

The rule of thumb was that when rates increase by 1% a bond or bond fund will see its price decrease by a percentage that roughly matches its duration. So a 1% rise in interest rates should have driven up the Vanguard Total Bond Market ETF (BND) by 6.2%, since it has a 6.2 year duration. However, the duration of the bonds held by funds fluctuates over the past few years and I have observed that durations fluctuate as bond prices rise and fall. Unfortunately, there is no way to see what BND's duration was back in December of 2021 before rates began to rise. All we can know for certain is that the current durations of these funds don't seem to match the changes that have occurred in their prices over the past 2 years.

This raises the question in my mind of how certain we can be that if rates stabilize investors can expect to see the prices of BND and other popular bond funds rise.

Bond Funds Have Been Forced To Sell Holdings At a Loss

There is the issue that bond fund holders have sold their ETF holdings at a higher rate over the past two years.

Below you can see what the flows have been into the Vanguard Intermediate-Term Bond ETF (BIV) and the Vanguard Intermediate-Term Corporate Bond ETF (VCIT).

BIV Bond Flows 2013 - Now

VCIT Bond Flows 2013 - Now

Only the Vanguard Total Bond Market ETF has not seen sustained negative flows, probably because it is included in so many robo investments and standard retirement and 529 portfolios

BND Bond Flows 2013 - Now

I cite these three different funds because all three of them currently have almost the identical duration. But the difference in how they may have been forced to sell bonds at a loss may affect their future performance in different ways.

Duration Is Not A Comprehensive Guide to How Your Bond Fund Will Perform

With that in mind, let's look at the most popular of Vanguard's funds, which are distinguished by the maturities and kinds of bonds they hold. Here are the most recently reported durations of these ETFs, taken from the Vanguard Advisors website. (As these ETFs are share classes of bond mutual funds Vanguard is allowed to report this data with a long lag).

Durations of Popular Vanguard Bond ETFs as of Sept 30, 2023

Source: Vanguard Advisor's Website

All but the Shortest Term Bonds Now Share the Same Duration

The reason for the very slight performance differences of the three funds that have durations approaching 6.2% is probably that they began with differing yields and as we have seen they have had differing selling pressures to deal with.

Vanguard Popular Bond Fund Prices Since January 2022

The Duration Rule of Thumb Did Not Explain The Actual Decline in Bond ETF Prices

As you can see, the share price of these bond ETFs since the Federal Reserve's benchmark rate was last .08% have not dropped as far as the 5.25% increase since January 2022 would have been predicted by their duration.

This points out, yet again, how little we can rely on the common wisdom about bonds that has been dogma for the 40 years from 1982 to 2022.

But the fact remains that an 18% or 19% decline in bonds has been devastating to investors who bought into the often repeated mantra, "Bonds are for safety." Retirees invested in target date funds that increased their bond holdings as they neared, or entered retirement have been particularly hard hit by this dramatic decline.

Have Rates Topped Out?

If you read popular financial sites you will see quite a few articles arguing that inflation has come down enough that the Federal Reserve will pause rates and then, very likely begin to lower them in 2024. This is not based on facts but on opinions and guesses about what will happen in the future. These opinions include arguments like,

• We will have a recession in 2024 and the Fed will have to lower
• The Housing market is in such bad shape that the Fed will have to lower
• Long bonds are seeing their prices surge thanks to "bond vigilantes" so there is no reason to raise the short rate the Fed controls anymore
• There is an election coming up so highly indebted voters must be catered to.

Countering these opinions are those of a quieter group others that argue that,

• The government hopes to inflate away inflation
• Inflation is not tamed
• There won't be an inflation in 2024 as jobs and consumer spending remain surprisingly high

My own belief is far simpler.

• Listen to what Jerome Powell and the other FOMC members have to say and believe it, ignoring the howls and screams of various partisan groups.

The Fed speakers have been relentlessly stating that their aim is to bring inflation down to 2%, a level that is still far from the current levels. In the November 1, 2023 press conference journalists kept trying to get Chairman Powell to say that the FOMC was tending towards pausing rates in preparation for lowering them. Powell stated very firmly several times that the committee had not the slightest discussion about lowering rates and that the issue is still whether they need to be raised again given that inflation is still much higher than the 2% target. Powell also emphasized the danger inherent in the public believing that inflation would continue to be higher than that target, which becomes a self-fulfilling prophesy and leads to "misery."

Powell also emphasized that the Fed will look at a very wide selection of data at every meeting and that the "dot plot" is only a measure of committee member sentiment at the time of the meeting, not a representation of a commitment to a policy. For now, he emphasized, labor and GDP are still robust and the FOMC committee sees no signs of recession.

The chart below shows you the most recent CPI data. The PCE, often called the Fed's favorite index shows a rise in personal consumption in September of 2023 of 3.7% compared to that in September of 2022. This increase was .1% less than the increase seen in the previous month.

Financial reporters continually ignore what Powell says at his press conferences. I cynically believe that this is because they want to tell readers what readers want to hear. But I have been watching these press conferences via video stream and can confirm that what Powell says, not what reporters try to get him to say is a very good guide to what rates will do for months to come and right now another raise is very much a possibility in my view, and maintaining rates at the current level for a year or more is almost certain, barring a huge, unforeseen disaster.

Bond Fund SEC Yields Are Tempting Many Investors Who Believe that Rates Won't Rise Further

Possibly because of the impact of journalists who keep predicting that rates will decline in a few more months, many investors are asking whether is it safe to invest in bond funds again now. These same investors are looking at the SEC yields of bond ETFs now, which appear very tempting. Many of these investors appear to believe that buying bond ETFs now, after the prices of them have dropped so steeply, is a way to lock in the high yields they see depicted in the reported SEC yields.

The SEC Yield Is A Poor Guide To Future Bond ETF Performance

But the SEC rate is a misleading metric in my opinion. Though the SEC mandates it be presented as a way of comparing bond funds to each other, it does not predict actual future bond fund yields. This is the text that Vanguard provides on its Advisor's site warning not to rely on the SEC yield for predicting income distributions.

Below are the SEC yields of the bond funds we just tracked.

Source: Vanguard Advisor's Website

As you can see, the actual distributions paid by these funds were considerably less than their SEC yields.

More to the point, the yield increase is not because the bonds in the fund are paying significantly higher monthly distributions than they did a year ago, but because the price at the time of the distribution, on which the yield is calculated, has continued to drop, raising the yield represented by the distribution on the day of the distribution.

If rates were to remain steady, the distribution yield might eventually rise to the SEC yield. But there is no guarantee this will happen. Bond funds buy and sell bonds continuously. Vanguard reports that BND has a 39.9% turnover at the December fiscal year end. Even if bond distributions were to rise to the level depicted by the SEC yield, it would be a very slow process. Below are the actual cash distributions of BND over the past twelve months.

BND Distribution Amounts YTD 2023

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As you can see, they fluctuate from month to month and have only risen modestly throughout this period while the price of BND dropped 5.11%.

Clearly, the only way that these bond funds might be "for safety" is if rates drop as dramatically as they have risen over the past 2 years, which would boosting their share prices. However, that kind of drop would, in time, lower the monthly yield as the actual distribution amount will continue to rise at modest levels before flattening and, eventually beginning to decline as the fund acquires new bonds with lower coupons.

But any sustained improvement in share price would only happen if bond rates fell a few percent, and there is no guarantee that will happen within the next year. If the Federal Reserve does what I believe they will do, which is maintain rates at the current level - or higher - to ensure that inflation is truly under control, we can expect the current rates to be maintained for a year or more and then come down gradually, barring a massive recession - something that we see no signs of now despite the financial press having predicted that one would happen within months - for the last two years.

Looking back at history we know that in the 1970s the Fed lowered rates too quickly and the result was a huge rebound. This Fed committee seems bound and determined not to make that mistake in my view. Especially since employment and consumer spending data continue to come in more robust than expected.

Bond Funds May Still Leave You With A Smaller Nest Egg Just When You Need Your Principal

Given that the distribution yields of all these bond funds including the riskier Intermediate Corporate Bond Index Fund is still well below what you can get for a Treasury bond purchased at your brokerage or a CD purchased either at your brokerage or at a high yielding credit union (check those rates here), I believe these funds are not smart investments now.

An actual bond or CD is almost certain, barring financial catastrophe, as they give you back all the money you invested in it on the date specified in the bond's description. Though a financial catastrophe would also devastate your bond ETF, there is no such guarantee that you will get your invested money back at any specific time with a bond fund. Though bond ETFs are described as if they had different maturities, short, intermediate, or "all," if rates rise steeply a few months before you need to sell shares of that fund the share price may be considerably less than what you paid to invest, no matter what the maturities the ETF invests in.

Throughout the 40 years when bond rates overall were dropping, the share price of your bond fund would rise slowly, giving you more total return than you got from just the dividend alone. This is why investors--and advisors--began to believe that "Bonds are for safety." But now that inflation has returned and has persisted for over 2 years you can't assume that rates will drop again to the sub 1% levels we all got used to thanks to QE. The Federal Reserve's policy can no longer be to artificially suppress rates. At best they will eventually drop rates to a "Neutral Level" which will match inflation, rather than today's "Restrictive Level" which is a percent or so above the current annual inflation rate.

Bottom Line: Bond Funds Are Still Not as Wise an Investment as Fixed Income With a Defined Maturity

As you can see, you really have little idea what you are buying now when you buy a bond ETF. You can't trust duration or SEC yield, which are the main metric that Vanguard and other fund purveyors disclose. Too much depends on whether or not inflation can be brought down to the Fed's 2% target and, most importantly, kept at that level. For now the safest approach continues to be to buy individual bonds or CDs that will pay you what you have invested at a known date. Select only maturities that you know you can hold the bond for, since selling a bond before it matures can lead to a capital loss.

If you want to lock down today's higher rates buy Treasuries with a 5 or 10 year maturity. Don't be tempted by individual Corporate issues unless you know enough to read the documentation describing the issue and to read the issuing corporation's quarterly reports.

Brokered CDs are just like bonds. You can't do an early withdrawal but must sell them on a secondary market that is quite illiquid, forcing you to offer well-above market rates to sell your CD. Brokered CDs can sometimes offer better yields than Treasuries, but remember that they, like bond ETFs, are subject to state and local taxes in a taxable account, unlike treasuries.

If you buy a CD directly from a bank or credit union that offers early withdrawal with a penalty (EWP), check out that penalty. The average EWP has risen quite steeply since rates have gone up making it hard to close out a longer CD without a significant loss.

If you can't make up your mind where to invest the money you can't afford to lose, money market funds offered by brokerages are all offering better yields than you will find in any of the bond ETFs we just looked at, and will continue to do so until the Fed lowers rates, which, as Powell disclosed recently, isn't something they have even begun to think about.

Psycho Analyst