When seen from a distance, core bond funds lately have had the deceptive appearance of ducks serenely gliding along the waters’ surface.
They’ve made money for investors. The largest bond mutual fund and exchange-traded fund — the Vanguard Total Bond Market Index Fund and the iShares Core U.S. Aggregate Bond E.T.F. — both gained more than 2 percent for the first three months of the year.
But that belies a two-week period in March when every corner of the bond market was furiously paddling to stay afloat. It’s worth looking closely at what happened, to be prepared for the possibility of further shocks in the future.
After withstanding the initial weeks of the stock sell-off, the same “flight to safety” that was roiling stocks started to shake up the bond market, too, as investors clamored to hold more cash, even if it meant selling staid, high-quality bonds.
Over the next two weeks, the Vanguard fund lost more than 6 percent and the iShares E.T.F. lost more than 9 percent. Both portfolios track high-grade indexes. MetWest Total Return, the largest actively managed core bond fund, lost nearly 8 percent. The Pimco Income Fund, which relies heavily on mortgage-backed bonds to deliver a yield that is double the payout of core bond funds, fell more than 12 percent. Vanguard Intermediate Term Tax-Exempt, the largest municipal bond fund, lost more than 10 percent.
“In many ways, this was more intense than in 2008,” said Rick Rieder, BlackRock’s chief investment officer of global fixed income, referring to the financial crisis.
Although back then, the bad news rolled out over many months before hitting a crescendo in the fall of 2008, “this transition was so fast,” Mr. Rieder said. Even rock-solid Treasuries weren’t immune from price declines as buyers demanded higher yields. (When yields rise, prices fall.) An index of intermediate term U.S. Treasury bonds lost 5 percent in the March bond sell-off. By comparison, during the worst of the financial crisis, the biggest drop for that index was a 0.24 percent decline from mid-September to mid-October 2008.
Our Coverage of the Investment World
The decline of the stock and bond markets this year has been painful, and it remains difficult to predict what is in store for the future.
- Discordant Views: Some investors just don’t see how the Federal Reserve can lower inflation without risking high unemployment. The Fed appears more optimistic.
- Weathering the Storm: The rout in the stock and bond markets has been especially rough on people paying for college, retirement or a new home. Here is some advice.
- College Savings: As the stock and bond markets wobble, 529 plans are taking a tumble. What’s a family to do? There’s no one-size-fits-all answer, but you have options.
- Enduring Meme Stocks: The frenzy that saw traders congregate on social media and push stock prices for companies like GameStop higher can no longer be explained as simply a pandemic phenomenon.
Then the cavalry arrived. On March 15, the Federal Reserve announced that it was stepping in with a huge program to buy bonds. Echoing the quantitative easing strategy the Fed employed during the financial crisis, it said it would buy government bonds, including mortgage-backed securities.
That was just the start. In the ensuing days, the Fed extended its shopping spree to the investment-grade corporate bond market and stepped into the investment-grade tax-exempt market as well. The stimulus bill that Congress passed later in March included a base level of $454 billion to support the Fed’s lending programs, and that backstop can be leveraged to provide an estimated $4 trillion to the Fed for the bond markets.
“The bond market is the grease that makes the wheels of the economy turn,” said Kathy Jones, chief fixed-income strategist at the Schwab Center for Financial Research. “It is how businesses, the government, the banking system get funded. What the Fed is doing is to try and keep the wheels turning.”
So far, it has been working. After the Fed’s intervention in the credit markets, bonds rallied in late March to put most bond funds that focus on investment-grade issues into positive territory for the quarter.
The Fed’s intervention was especially calming for bond E. T. F.s, where the share price can trade above or below the value of the underlying bonds, which is called the net asset value. Typically, E.T.F. fund prices closely track the N.A.V. During the sell-off, bond E.T.F. prices traded at big discounts, which was of concern for short-term traders, though not something long-term investors need to worry about.
Ms. Jones suggests following the Fed’s lead as the coronavirus crisis continues to unfold. “Buying what the Fed is buying is not the worst investment strategy.” Initially, in March, that only included investment grade bonds. In early April, the Fed announced that it would extend its support to high-yield bonds as well.
Most core bond index funds and E.T.F.s stick to investment grade. For long-term investors using bonds to provide diversification when stocks fall, “a high-quality core intermediate term fund is a fine place to be,” says Amy Arnott, portfolio strategist at Morningstar. “But you want to check that your fund is not dipping into below-investment-grade,” given the dark economic storm clouds.
Morningstar divides core bonds into two groups, those that strictly track an investment-grade index such as the Bloomberg Barclays U.S. Aggregate Index, and those that have some leeway to stray from the index, which are designated “core plus.” At year-end, the average intermediate core bond fund had less than 5 percent in bonds rated below investment grade, and the average intermediate core-plus bond fund had more than 10 percent.
One risk with all core bond funds that track the Bloomberg Barclays U.S. Aggregate Index is that half of the benchmark’s corporate bond holdings are issues that are rated BBB, which is the lowest rung within investment-grade bonds. If a BBB-rated bond issuer struggles to stay current with payments during this economic crisis, its rating could be lowered, effectively sending it off the edge of the investment-grade cliff into “junk” bond status. That concern grew in March; the debt of S&P 500 companies with BBB ratings fell nearly 15 percent.
An alternative to a fund that tracks the Bloomberg Barclays Aggregate index is to think about your bond portfolio as two distinct pieces: one for diversification and the other to earn more yield. For the best diversification ballast when stocks are falling, Treasuries remain the gold standard.
But the popular strategy of owning intermediate term Treasuries isn’t ideal now, given that the yield on a five-year Treasury note is less than 0.4 percent. Mr. Rieder suggests mixing cash, such as certificates of deposit, along with longer-term Treasuries, where yields are higher.
In early April, it was still possible to lock in a yield of 1.85 percent for 12 months with a high-yielding certificate of deposit offered by online savings banks. Certificates of deposit maturing in two, three and five years offer higher yields.
While the diversification piece won’t deliver much in the way of income, some good news is that March’s volatility caused the yields on high-quality investment-grade corporate and securitized bonds (mortgages and other assets) to rise. The Fidelity Total Bond Fund recently had more than 70 percent of its assets in bonds rated A, AA or AA and paid a 2.9 percent yield. The TCW Total Return Bond Fund focuses on mortgage- and asset-backed bonds — more than 80 percent of its portfolio is rated AAA — and recently yielded 3 percent.
The most compelling corner of the investment-grade bond market right now may be the one that got roughed up the most in March. An index of high-grade municipal bonds lost nearly 11 percent during a two-week stretch as investors eager to raise cash or rebalance into battered stocks created a logjam of too many sellers.
Paul Malloy, head of municipal bonds at Vanguard, likened what happened to pouring “a bucket of water into a sink,” and then waiting for the water to eventually drain through the clogged pipes. With some plumbing help from the Fed, the pipes did clear, and the index rebounded more than 7 percent in the last week of March.
Mr. Malloy describes the sell-off as “unnerving, but not concerning.” In the financial crisis, there was abject concern that the market would not be able to function because financial institutions that were the heart of the trading market were faltering and municipal bond insurers were failing.
None of that is in play now. “This was a good functioning of capital markets,” Mr. Malloy said. He added that as things have calmed, investment-grade municipal bonds are now “very attractive,” as yields remain well above where they were before the market turmoil hit.
In early April, the 1.8 percent yield of the Vanguard Intermediate-Term Tax-Exempt fund was nearly triple the yield of a 10-year Treasury bond. And that’s before factoring in tax breaks.
Municipal bond interest is typically free of federal income tax. Income paid on Treasuries (and corporate bonds, for that matter) is taxable. For someone in the 24 percent federal tax bracket, a 1.8 percent municipal bond yield is the equivalent of earning 2.4 percent on a taxable bond. If you’re in the 32 percent federal tax bracket, the 2.6 percent taxable equivalent yield is nearly one percentage point higher than the average yield on core taxable bond funds. You may be eligible for a state tax break, too.
Mr. Malloy is confident that high-quality bond issuers will be able to weather the expected near-term decline in taxes and revenue as the economy shelters in place. “They’ve got enough cash to make their way through this. You would need multiyear shutdowns in a lot of the issuers” before defaults in high-grades would become an issue. And in these dark days, even that seems highly unlikely.