How bond ETFs can help advisors reshape client portfolios

• Yields are back across fixed income markets, giving advisors a chance to reinvest clients’ excess cash and reassess their bond allocations.
• When creating your portfolio blueprints, it’s helpful to remember the three roles bonds can play in portfolios: diversification, capital preservation, and income.

The U.S. Federal Reserve has been battling inflation with 11 interest rate increases since March 2022. This rapid rise in interest rates contributed to a 13% fall in the Bloomberg U.S. Aggregate Bond Index in 2022 — quadrupling the prior worst calendar year and wiping out five-plus years of gains.¹ As bond prices declined, many investors chose to sit in cash equivalents; money market fund assets increased from $4.5 trillion to $5.5 trillion from March 2022 to August 2023.²

Based on BlackRock's analysis of the typical advisor moderate (60/40) model portfolio, many portfolios are still underweight fixed income and overweight cash.³ Notably, bonds tend to outperform cash and have price appreciation when:

• The Fed funds rate is higher than inflation: As of the August CPI print, year-over-year inflation is down to 3.7% and the Fed Funds target rate is 5.25% to 5.50%.⁴
• The Fed stops raising rates: At its June 2023 meeting, the Fed suggested just one or two additional rate hikes before reaching the terminal, or peak rate, for the current cycle.
• Short-term rates are higher than longer-term rates: The yield curve is inverted with 3-month Treasury yields at 5.4% and 10-year Treasury yields at 4.1%.⁵

With the fed funds rate is at its highest level in 22 years,⁶ investors have a generational opportunity to get back into bonds. The recent U.S. credit rating downgrade by Fitch is another signpost on the road to restructuring client portfolios – and rethinking the role fixed income plays in them.

With higher rates, advisors can now add duration to client portfolios with more peace of mind given the “yield cushion” can limit downside risk. And should rates fall, the upside potential could be high by locking in today’s rates.

Yield cushion: With higher rates, investors can add more duration as their yield cushion can help offset any price losses . Duration is a measure of interest rate sensitivity – for every 1% rise in rates a bond’s price will decline by its duration. For example, a bond with a duration of 5 years will see a price decline of about 5% if interest rates rise by 1%. This is where the yield cushion comes in – because rates are higher, the income generated off that hypothetical bond will likely offset its price decline even if the fed funds rate rises further.

Bond ETFs have transformed fixed-income investing and are on the path to reach $5 trillion in AUM globally by 2030.⁷ Many advisors are turning to bond ETFs as a cost-effective way to provide clients liquidity, transparency and precise access to fixed income exposures.

When designing a client’s portfolio, it’s important to consider the three key roles bonds can play: equity diversification, capital preservation, and income. The prioritization of these objectives will vary depending on the client’s specific needs and broader asset allocation. The good news is today’s higher-rate regime has implications for each:

Equity diversification: For growth-oriented portfolios with substantial equity allocations, bond holdings should seek to provide a counterbalance. High-quality bonds have traditionally exhibited negative equity correlations, with 2022 (when both sides of the portfolio declined) being a notable exception.ⁱ

Going forward, investors can have more confidence in bonds’ diversification potential: rate moves can be less one-directional when the Fed stops hiking, and high starting yields act as a cushion for total returns.

If the primary goal is to provide diversification to clients’ equity allocations, advisors may consider the iShares Core U.S. Aggregate Bond ETF (AGG) and iShares U.S. Treasury Bond ETF (GOVT).

Capital Preservation: With their periodic cash flows and known maturity values, bonds have been commonly held for capital preservation. Lower maturity bonds tend to have less price fluctuations and can be used by investors to add stability to portfolios. However, for most of the last 15 years, low duration bonds also meant low return potential. If investors were looking for higher yields, then they would need to seek bonds with more credit risk or longer maturities. Today, short-term maturity bonds can offer both positive income and stability. 

For capital preservation and the potential to earn more income than sitting in cash, advisors may consider adding the iShares 1-3 Year Treasury Bond ETF (SHY) and iShares 1-5 Year Investment Grade Corporate Bond ETF (IGSB) to client portfolios. It’s important to note that an investment in fixed income funds is not equivalent to and involves risks not associated with an investment in cash.

Income: From 2013 to 2021, high yield and emerging market debt were the only two fixed-income asset classes to offer more than 4% yields. Currently, over 50% of fixed-income assets yield over 4%. Income focused investors or investors without much equity market risk could consider accessing high yield bonds with iShares Broad USD High Yield Corporate Bond ETF (USHY) and emerging market debt with iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB).