Bond ETFs: Long, Intermediate, Or Short?

Bonds are being better received these days as investors seek safety amidst high inflation, a volatile stock market, uncertain Fed policy, and a possible recession. According to etf.com just days ago:

U.S. fixed income ETFs hauled in $39.7 billion, more than five times the $7.2 billion that flowed into U.S. equity funds, Bloomberg data shows. The pace of the move into bonds accelerated from last year, when they brought in $99.2 billion versus $15.1 billion for stocks.

Of course, most bonds performed extremely poorly last year, not seeming to be much of an alternative to stocks, as Fed-controlled interest rates rose at a rapid rate hurting bond prices. But clearly, the Fed is much closer to an end of their campaign to control inflation than they were last year.

This argues for a stabilization in rates in the months and even years ahead. In fact, for the first three months of 2023, Vanguard Total Bond Market ETF (BND), the bond ETF with the most assets under management, has gained 3.18% as compared to a 13.15% loss last year. And, for over six months now, the price of BND has wound up about the same in spite of Fed fund rate increases amounting to 2.5%.

But safety is not the only reason for bond ETFs' new-found popularity this year. While at the beginning of last year, such funds were offering minimal dividends, this year the 30-day SEC yield of BND, is a respectable 4.17%, which, according to Vanguard is based on holdings introduced into the portfolio over the prior 30 days. Therefore, it seems there is a good chance the fund will be returning at least 4.5% in dividends alone over the entire year with the possibility of an even greater total return if gains in the price continue to rise. (Note: the Fed is highly likely to raise rates in at least one more 0.25% move.)

Of course, BND is just one bond ETF alternative. It is considered in the intermediate-term maturity category. (Actually, though, it has bonds a minority of bonds in a variety of maturities.) But here is the primary question bond investors should be asking themselves: If bonds are poised to do relatively well this year, what maturities should an investor be considering focusing now, either this intermediate term category, or shorter or longer-term ones? For example, while BND has returned the above mentioned 3.18% this year, the Vanguard Long-Term Bond ETF (BLV), with a longer-term focus, has returned 6.26%.

If bonds continue to do quite well this year, likely because the Fed starts dropping rates or investors assume they will in the near future, long-term bonds should outperform bonds with shorter maturities. That is because when interest rates are rising, shorter maturities tend to do better, but when rates are falling, longer terms bonds usually do better. Since many investors have assumed rates may start to fall sometime this year, this possibility could explain why the longer-term bonds are doing better so far this year. But this, in my opinion, is quite unlikely to happen. Chairman Powell, as well as some other Fed members, have already stated as much.

If, on the other hand, the Fed continues to raise rates beyond current projections or fails to drop them as some " jumping the gun" investors seem to expect, bonds of shorter maturities should do better than long-term bonds.

But since no one knows what the Fed will do in advance, shorter-term bonds will remain a safer bet. It should be noted that since the Fed has been raising rates non-stop for about the last 12 months, the return on BLV has been a negative -13.40%, but the return on BND has been considerably better, but still negative, at -4.73%.

And what about the returns for Vanguard Short-Term Bond ETF (BSV) over the last 12 months? They come in at -0.36%, confirming that as interest rates rose last year, shorter-term bonds were a much better place to be than either intermediate or longer-term bonds, hardly losing anything. But it appears that, since the beginning of 2023, longer-term bonds are now being favored by investors, resulting in higher returns for either BND or BSV.

Right now, in the first few months of the year, as I've stated above, it appears that many investors are anticipating the Fed will stabilize or drop rates fairly soon, but, if the Fed doesn't, shorter term maturities will still be the best place to be. But note that the 30-day SEC yield for BLV at 4.72%, which is better than the same yield for BSV which is 4.49%.

Thus, investors are getting more yield, that is 4.49% vs. 4.17% by investing in short term bonds, BSV, with less risk, than BND. This is due to the occurrence of an inverted yield curve where higher rates jump ahead of some longer maturity bonds unlike what is usually the case. While it may be tempting to switch one's asset allocation to a much higher percentage of assets into short-term bonds, the risk is that once the phenomenon of higher rates for taking less risk, as the inverted yield curve returns to a normal upwardly sloping maturities curve, an investor may miss out on larger gains with longer maturities.

Investors should be aware that longer term bonds are riskier than shorter term ones. So, is getting a little extra yield by investing in the longest maturity bonds worth the added risk? Not in my book. And while short-term bonds may be the most appealing right now looking in a one-year rear view mirror, intermediate term bonds appear to be the best compromise with only a somewhat lower yield than an ETF such as BLV, but with less risk, taking into account all possible future moves by the Fed.

Further backing this up is an article on the Schwab website which states that when considered on a historical basis, funds such as BND have done better than funds such as BSV when the Fed is done hiking interest rates.

The above article gives the following example:

...in December 2018 the Fed hiked rates for the ninth and final time in that rate-hiking cycle. Over the following 12 months, an index of intermediate-term bonds returned 6.7%, relative to 2.2% for an index of short-term bonds.

Of course, past performance is no guarantee of future results.

Mutual fund investors should remember that the above three ETFs are virtually the same as their mutual fund class equivalents, Vanguard Total Bond Market Index Admiral (VBTLX), Vanguard Short-Term Bond Index Fund Admiral (VBIRX), and Vanguard Long-Term Bond Index Fund Admiral (VBLAX).