A Few Factors to Check Before Buying Bond ETFs
The Federal Reserve’s aggressive rate-hiking campaign a few years ago triggered a historic bond-market selloff. Vanguard Long-Term Treasury Index Fund ETF Shares VGLT remains nearly 40% below its all-time high on a total return basis. However, today’s bond market looks markedly different, per a Motley Fool article, as quoted on Yahoo Finance.
While the Fed could still raise rates later this year, yields are unlikely to surge as they did in 2022. Bonds now offer much higher starting yields and greater income potential, per the above-mentioned article.
Let’s delve a little deeper.
Downside Risks in the Bond Investing
There are two key risks: default risk and interest-rate risk.
Default risk is the chance that a bond issuer fails to pay interest or return principal. Longer-maturity bonds generally have greater exposure to economic and interest-rate shifts.
Interest-rate risk is the chance that a bond loses value as market rates rise. A bond duration measures how much a bond’s price may move when rates change. A higher duration means greater price risk. A bond with a five-year duration could fall about 5% if rates rise 1%.
Inside Rising Bond Yields
Long-term yields have been rising, with the 10-year Treasury yield reaching 4.74% on Aug. 21, 2026. Its yearly closing high through Aug. 21, 2026 is 4.75%, versus a low of 3.97%. The 30-year Treasury yield reached a yearly closing high of 5.31% on Aug. 17, compared with a low of 4.64% on Feb. 27.
The five-year Treasury yield reached a yearly high of 4.46% on July 23, 2023 and a low of 3.51% on Feb. 27.
How to Choose Bond ETFs in the Current Scenario?
There are several factors investors should consider before buying bond ETFs amid the current rising rate scenario.
Yield and Income Potential
The two-year Treasury yield hit a yearly closing high of 4.37% and a low of 3.38% through Aug. 21, 2026. Three-month Treasury yields reached a yearly high of 3.96% and a low of 3.62%.
If inflation rises, the Fed could hike rates, boosting short-term yields and ultra-short-term Treasury ETFs.
Look for ETFs With Lower Interest Rate Risks
With short-term Treasury yields around 4.25% and uncertainty over inflation, Fed policy and long-term borrowing costs, short-term bond ETFs offer a compelling mix of income, liquidity and lower duration risk. In short, short-term bond ETFs can provide relatively high yields without taking much interest-rate risk.
Closely Look for Default Risks
While shorter duration reduces interest-rate sensitivity, e high-quality government securities carry very low default risk. Schwab Short-Term U.S. Treasury ETF SCHO charges 3 bps and yields 3.87% annually. It is a low-default-risk bond ETF and is up 0.12% over the past month.
Investment-grade corporate bond ETFs also offer higher credit quality than high-yield or junk bonds, although corporate bonds carry more credit risk than government securities.
iShares 1-5 Year Investment Grade Corporate Bond ETF IGSB charges 4 bps and yields 4.61%, versus iShares 0-5 Year High Yield Corporate Bond ETF SHYG, which charges 30 bps and yields 6.99%.
Why Corporate Bond ETFs Look Attractive Now
Currently, default rates for high-quality U.S. investment-grade corporate bonds, including BBB/Baa and above, remain near 0%, per New York Life Investment management. U.S. high-yield corporate bond trailing 12-month default rates are around 2.8%, relatively flat and within Fitch Ratings’ 2.5%-3% forecast range. Thanks to decent default rates, investors can consider ETFs like IGSB.
iShares Interest Rate Hedged Corporate Bond ETF LQDH is another option. The $545 million-asset ETF hedges the interest-rate risk of U.S. dollar-denominated investment-grade corporate bonds. It charges 24 bps and yields 5.86% annually. LQDH is down only 0.6% over the past year and 3.3% over five years.
Total-Market Bond ETFs: Another Interesting Option
Total market bond ETFs combine U.S. Treasuries and corporate bonds, offering a different risk-return profile. Corporate exposure can boost yields but adds credit risk.
iShares Core Universal USD Bond ETF IUSB has much lower duration and therefore less interest-rate sensitivity than long-term Treasury ETFs like iShares 20+ Year Treasury Bond ETF TLT.
TLT yields 4.73%, charges 15 bps in fees and has an effective duration of 14.90 years, while IUSB yields 4.26%, charges 6 bps and has an effective duration of 5.53 years. IUSB holds about 40% in Treasury bonds, followed by 20% in MBS pass-through securities and 18% in the industrial sector.
Bottom Line
In a nutshell, elevated yields make bond ETFs attractive for income, but investors should weigh yield, interest-rate sensitivity and credit risk before investing.
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iShares 20+ Year Treasury Bond ETF (TLT): ETF Research Reports
iShares Core Universal USD Bond ETF (IUSB): ETF Research Reports
Schwab Short-Term U.S. Treasury ETF (SCHO): ETF Research Reports
iShares 0-5 Year High Yield Corporate Bond ETF (SHYG): ETF Research Reports
iShares Interest Rate Hedged Corporate Bond ETF (LQDH): ETF Research Reports
iShares 1-5 Year Investment Grade Corporate Bond ETF (IGSB): ETF Research Reports
Vanguard Long-Term Treasury Index Fund ETF Shares (VGLT): ETF Research Reports
This article originally published on Zacks Investment Research (zacks.com).