Don’t Make This Mistake When Chasing Higher Bond Yields

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. Higher bond yields are attracting more attention and more money. US bond ETFs pulled in almost $54 billion in August. Core and core-plus bond ETFs make up about $8.5 billion of that. These funds tend to provide shelter during market storms to ease a portfolio’s rocky moments. They also provide steady and predictable income. As bond rates sit higher than they have in the past, how can you benefit while also taking a conservative approach? Dan Sotiroff is the associate director of US passive strategies research for Morningstar. Thanks for being here, Dan.

Dan Sotiroff: You’re welcome.

Hampton: Now, core and core-plus bond ETFs can play an important role in creating income in a portfolio. How do these funds work? What do they invest in and for how long?

Sotiroff: We could split that into two broad camps. We’ll go the active/passive route. I think that’s the most obvious one and the easiest one to discuss these in. On the passive side, the indexing side, we’re talking about index ETFs that would track something like the Bloomberg Aggregate Index, broad bond market exposure, or at least that’s what it’s trying to do to the best of its abilities. On the active side, you’re looking at ETFs that are going to reasonably sort of replicate certain characteristics of that broader bond market, but they’re going to deviate in a few ways. One way they’re going to be similar is that they’re probably going to have a similar effective duration because they land in this intermediate core-bond category, and that’s really the big thing to key off of. But they are actively managed, so they’re going to look different from the bond market in a few key regards because the managers are trying to outperform, and in order to outperform, they have to look a little bit different.

Big things there to look for are that active managers are probably going to be taking on a little bit more credit risk, turn a little bit higher yield. They may go outside of the bonds that the index is allowed to hold. They may find some stuff out there that is more difficult to trade; maybe it’s mispriced, and they can get some deals that way. Again, it’s all in this effort to outperform. They’re going to look different in those regards and maybe a few others. But the bigger thing here is that these are really meant to be sort of a long-term core portfolio holding. And yes, they generate income. We actually have interest rates now. We’ll talk about that a little bit later, but these are meant to be a core portfolio holding, really, to provide ballast for your portfolio and reduce risk because bonds in general are just less risky than stocks are. That’s really what these core and core-plus bond ETFs are meant to serve. Long-term core portfolio holding is what you should really be thinking.

Hampton: What are the obvious and not so obvious differences between the passive and active ETFs?

Sotiroff: Yeah, so maybe let’s address a similarity here. And that is, again, we beat this point to death all the time, which is that fees matter. Regardless of which approach you’re going after, stick to the stuff that’s lower cost; that’s always going to be an edge no matter what you’re doing. Now, that said, the bond market is one where active managers actually have a little bit of an edge, and it’s because the indexes are just really, really conservative and they don’t really cover the entire bond market. What I mean by that is a lot of the broad bond market indexes are going to be really Treasury-heavy. They’re like 40-some percent Treasuries right now, and those are the least risky bonds out there in the market. And then the other thing is they don’t encompass everything. There are certain types of bonds that are just really difficult to trade. They don’t trade that often. And because of that, they don’t really lend themselves to indexing very well. They’re not going to be in the indexes, and that’s sort of the opportunity for active managers to go out to find those types of mispriced bonds, buy them, hold them, and get some outperformance in that way. That’s really where you’re going to see the split between active and passive.

We should say, when you get into active bond management, the outperformance is actually more legitimate than it is when we talk about equities. When we talk about equities, the success rates of active managers are very, very low. When you go into a lot of bond categories, a lot of active managers actually do have a reasonable chance of outperforming. We see it in the success rates. It’s not uncommon in some categories to see success rates for active managers of 40% to 50%, if not even higher than that. You still have to do your homework; you still have to make sure you’re getting a good process and a good manager and all that type of good stuff, but the chances of getting a good manager and them actually adding value over their fees is going to be a lot higher.

Hampton: What do you make of the billions of dollars that have flowed into core and core-plus bond ETFs this year?

Sotiroff: Yeah, I think it’s for a few reasons. We actually have interest rates now. If you go back 10 years, or even during covid, interest rates were near zero, so you just weren’t getting a whole lot. When you look at bonds, the yield that you earn on those bonds or your bond fund is more or less the total return that you should expect over a certain horizon. The shorter bonds are going to be a shorter horizon; longer-term bonds are going to be a longer horizon, but that’s the basic idea—yield is generally an indicator of expected return. Now, you’ve actually got yields. The short-term yield is around 4%, and we’re recording on Sept. 16. Just yesterday, we saw the 10-year hit 5%. We actually have an upward-sloping yield curve, which means we’re kind of back to a healthier interest rate environment now.

But that’s kind of one of the big drivers: You’re actually getting some return, some income out of bonds now today. In general, that makes it more attractive. The other thing, and I hope this is part of it, I don’t know for a fact if it is—it’s a little bit of a guess on my end—but with each passing month, the market is getting riskier and riskier and more and more concentrated, the stock market, that is. I hope that some of it is people taking some risk off the table, reallocating the bonds, basically doing some rebalancing trades there to bring their risk/reward back in line now that we’ve had a market that just seems to be going up and up and up for years and years and years. I hope that some of it is derisking and taking some off the table and getting their portfolios into a healthier position going forward.

Hampton: Let’s talk about how active fund managers can use their tools and resources to pounce on higher bond rates. What does that look like, and how would that benefit investors?

Sotiroff: Yeah, so I kind of hinted at it before. It’s really going outside of the stuff that the indexes can’t really invest in, or they don’t invest in for various reasons. That’s where they’re going to add the most value because that’s where you find bonds that are probably going to be more mispriced. They probably don’t trade all that often. Those are going to be sort of the areas that active managers can actually add value. They’re not going to add a lot of value in Treasury bonds that are heavily traded every day. Everybody kind of knows what they’re worth. There just isn’t a lot of value to add there. So, holding bonds that aren’t eligible for the index because they’re too small or they’re just not traded frequently enough is going to be probably the big one. That’s where you’re going to find the mispricings. It’s probably the single biggest differentiator between active and passive, kind of like I said before.

The other thing we should point out here is what the difference is between core and core plus? It just seems like maybe a naming convention thing, but there is some substance beneath it. With core, at least in the indexing world, with core, you don’t hold any high-yield bonds. It’s all investment-grade corporates, Treasuries, mortgage-backed securities, that type of stuff. When you go to core plus, now you can add in a little bit more high yield. You do get a little bit more credit risk and a little bit higher rate of expected return, I should say, because of that. And right now, I think if you look at a core-plus index, which I’ll mention here in a little bit, I think it’s somewhere around 5% or 7%, somewhere in that range, allocation to high yield right now. It’s not huge. We’re not talking about massive allocations to high-yield bonds or anything like that, but you do get a little bit more, and that can help out your expected return.

Hampton: Can do-it-yourself investors or passive ETF investors mimic active fund managers’ moves?

Sotiroff: No, and that’s something we should be very clear about here. The bond market is not like the stock market. There is no centralized exchange where prices are quoted every 15 seconds or whatever it is now. It’s very difficult for individual investors to go out there and actually buy individual bonds in any meaningful amount and do so in a cost-effective way. You can maybe do that with Treasuries if you want because the market is so heavily traded and everybody kind of knows what they’re worth. But once you get outside of that, once you get into corporate bonds and MBS and that type of stuff, you really need to be a larger institution with a big pool of money behind you in order to make meaningful cost-effective trades there. That’s something that I think you’re better off just outsourcing to an index or an active manager, whichever route you want to go down. It’s very difficult to do that type of thing. So, I say just hands off, don’t even try to do it.

Hampton: What do higher bond yields mean for those seeking income now or in retirement?

Sotiroff: Well, the obvious one is that you’re getting more income now than you were five or 10 years ago because interest rates are higher. That’s probably a statement of the obvious there. But probably the bigger thing to realize here is, look, that’s not in your control. Yields are going to come and go. They’re going to rise and fall over time. Bond prices are going to follow accordingly. According to bond mechanics, they’ll fall or rise over time as well.

The bigger thing to realize here: None of that is in your control. It is what it is. Be very careful about chasing yield because that’s going to lead you down a bad path, and it’s probably going to hurt you more than it helps you. I say that because I know there are segments of investors out there that maybe want to do that type of stuff and try to time the market and get out and play games with what they think the Federal Reserve is going to do and line up their investments accordingly. That’s sort of a recipe for disaster, and it’s not something you should be getting into. If you’re in an actively managed fund, let the active manager do that to the extent that they’re allowed to do that within the process that they’re following, but don’t try to do it on your own. It kind of goes back to the previous question; don’t try to do this stuff on your own. It’s very, very difficult, and you’re probably going to hurt yourself in the process.

Hampton: Which core bond ETFs earn Gold or Silver ratings for Morningstar?

Sotiroff: Yeah, so there are a couple of them. I guess we’ll break this down by passive and active. Passive stuff, kind of like I’ve been hinting at here: Anything that tracks the Bloomberg Aggregate Bond Index, we’re big fans of. Pretty much every asset manager has an ETF or a mutual fund that’s tracking that index because it’s kind of ubiquitous, and they’re all very low cost. They often have competitive fees. The two biggest ones out there—and I think these are the two biggest passively—or, actually, I should take that back. I think these are the biggest fixed-income ETFs, period. Vanguard Total Bond Market ETF. The ticker is BND; that’s charging three basis points. And then the competitor at iShares, iShares Core U.S. Aggregate Bond ETF also charging three basis points. The ticker is AGG.

On the active side, we got two options here, and this is in the intermediate core-bond Morningstar Category. Fidelity Investment Grade Bond ETF FIGB charges 36 basis points. It’s actively managed, so it’s going to be a little bit more expensive, but it has generally justified its fee. They’ve outperformed after fees. Another one that’s also rated Gold is Vanguard Core Bond ETF VCRB. That’s only a few years old, charges 10 basis points, much cheaper, but it’s a little bit more conservatively managed. We still like it. The ticker on that one is VCRB if you’re interested. That’s what I would look at if you’re looking at just sort of core investment-grade bond funds.

Hampton: And which core-plus bond ETFs do Morningstar analysts like?

Sotiroff: Again, so we’ll break this down by index and active, right? So, anything tracking the Bloomberg Universal Index. The big difference here, like I said before, is that they’re going to have a little bit more high yield in them than the Bloomberg Agg or any ETF that’s tracking Bloomberg Agg. So, iShares Core Universal USD Bond ETF charges six basis points; the ticker on that is IUSB. Vanguard last year, late last year, came out with a competitor to that, Vanguard Core-Plus Bond Index ETF, that charges five basis points. The ticker on that is BNDP. Both tracking the same index at the end of the day, so pick one—whichever asset manager is your favorite. That particular index ETF is not that common. Really, iShares kind of owns the market in that, and then Vanguard is trying to compete with it now. So, one of those. Either one of them is great. They’ve got great management teams behind them, so I trust that their tracking error is going to be pretty solid over time.

On the active side, we got a few that are rated Gold that have either a High

or High Pillar rating, so I’ll go through those. Fidelity Total Bond ETF has long been a favorite of ours. It’s 36 basis points. The ticker is FBND. JPMorgan Core Plus Bond ETF charges 37 basis points, so similar fee level; the ticker on that is JCPB. And then Pimco Active Bond ETF is a little bit more expensive, 45 basis points, and the ticker on that one is BOND. Easy one to remember if you’re looking for a bond ETF, but you can read more about those on Morningstar.com. Those have been some of our favorite core-plus bond ETFs for a while now, so pretty confident that those can serve well as a long-term core holding.

Hampton: What’s the takeaway for income investors eyeing core and core-plus bond ETFs?

Sotiroff: Yeah, I think don’t get too creative with this stuff. This is meant to be a core long-term portfolio holding. Don’t get too cute with it. Go for the low-cost stuff, the stuff that’s really well managed if you’re on the active side. There are great options, passive and active out there. And again, just remember, these are primarily used as a way to reduce risk in your overall portfolio, not something you should be trying to time to improve performance or chase yield or anything like that. Use them as a core holding as they’re intended to be.

Hampton: Dan, thank you for coming to the table.

Sotiroff: You’re very welcome. Thank you.

Hampton: That wraps up this week’s episode. Thanks for making this show part of your day. A couple of reminders: Give Investing Insights five stars on Apple Podcasts to help others find the work we’re producing for you, and subscribe to Morningstar’s YouTube channel to watch new videos from our team. Thanks to senior video producer Jake VanKersen and associate multimedia editor Jess Bebel. I’m Ivanna Hampton, editorial multimedia manager at Morningstar. Take care.