Fixed Income
Jan 30, 2025
Key Takeaways
- Long-dated bonds have been adding risk to multi-asset portfolios in today’s environment of elevated stock/bond correlations and heightened bond market volatility.
- Investors may be over-allocated to long duration assets: A full 42% of the Aggregate Bond Index – as well as the average advisor portfolio – is allocated to bonds with 10+ years to maturity.
- Today's broader bond universe may offer opportunity to reduce risk and increase yield by moving beyond core bonds. We believe investors may benefit from a more even split between core bonds and “plus" sectors, and see opportunity in actively managing a broad, diversified set of those plus sectors, such as through the iShares Flexible Income Active ETF (BINC).
As we kick off a new year, bond investors are faced with a puzzling state of affairs: despite the Federal Reserve lowering the Federal Funds Rate (FFR) by a full 1% over the last few months of 2024, longer-term bond yields have risen sharply. The 10Y treasury yield has risen from 3.65% prior to the Fed’s September cut to 4.61% as of January 16th.1
Longer dated yields typically fall following Fed cuts… but not this time
Change in 10Y treasury yield in the three months following the first Fed cut, 1984-2024
Just when history would suggest bonds should start doing well, performance went in the opposite direction: the Bloomberg Aggregate Bond Index lost 3.7% between Sept. 17, 2024 (the day prior to the Fed’s cut) and Jan. 16, 2025.2
Does this spike in yields create a buying opportunity? Or might this phenomenon last longer, demanding a reconsideration of what an “optimal” fixed income sleeve might look like?
The US fiscal deficit creates long-term challenges for bonds
The U.S. national debt stands at $36T to start 2025 – six times the $6T in 2000. The debt now represents a full 124% of GDP, and the Congressional Budget Office (CBO) is projecting the debt to increase over the next 10 years.3
That growing debt translates into a fiscal deficit, which now stands at 6.2% of GDP. Like the debt number, this figure is projected to increase: the CBO estimates it’ll grow to 6.9% by 2034.4
The U.S. fiscal deficit is projected to increase over the next 10 years
U.S. federal deficit as % of nominal GDP, with recessions shaded
Source: Bloomberg as of 1/14/25.
We’re now faced with a situation where the ongoing deficit is combined with a strong economy in which persistent inflation could keep the Fed from cutting the FFR much further. This leads us to believe we could be in for more volatility and limited appreciation potential from longer-term bonds.
The bond market itself has seen its duration increase significantly over the years. A full 42% of the US Aggregate Bond Index has a maturity profile of 10+ years, implicitly increasing the risk of the many core bond strategies that are benchmarked to it. We’ve seen this extension risk reflected in advisor portfolios as well: 42% of the average advisor’s bond sleeve also has 10+ years until maturity.5
Long bonds may come with more risk and less diversification today
The S&P 500 lost money in 14 of the 36 months between 2022 and 2024. While losing money is always painful, these months felt worse since the average core bond strategy also lost money in all 14 of those down months.
Bonds fell in tandem with stocks over the last three years
Average monthly return when the S&P 500 was negative, 2022-2024
Source: Morningstar as of 12/31/24. “Agg bond index” represented by the Bloomberg U.S. Agg Bond TR Index. “Average core bond fund” represented by the Morningstar US Fund Intermediate Core Bond category average. Past performance does not guarantee or indicate future results. Index performance is for illustrative purposes only. You cannot invest directly in the index.
What this means for investors and their bond portfolios
In a world of negative stock/bond correlations, high bond volatility can work for you: zigs in the equity market can be offset by zags in the bond market. However, with stocks and bonds now more highly correlated – and projected to remain that way given the deficit and inflation outlook – higher bond volatility leads to more volatile multi-asset portfolios as that diversification recedes.
As such, investors may want to consider reducing their exposure to long duration bonds – a trade that doesn’t even cost you much in yield today. There’s still a reasonably low term premium for long-dated bonds. And there are many more opportunities to replace and enhance your bond portfolio’s risk/return profile with a diverse set of shorter duration bonds.
An evolving bond market creates opportunity
While most investors are familiar with the Bloomberg U.S. Aggregate Bond Index (it’s been the de facto benchmark for bonds for nearly 50 years, with $2.2T in assets benchmarked against it), they may not be as familiar with the growing universe of bonds that are excluded from it. We call these “plus sector” bonds, and they could have the ability to deliver higher risk-adjusted yields than their traditional “core” bond counterparts.
The bond market has evolved
Market capitalization weights of U.S. bond market sectors
Source: Bloomberg as of 9/30/24.
Consider floating rate treasuries, or AAA-rated collateralized loan obligations (CLOs). Strategies that aim to capture these parts of the market, such as the iShares Treasury Floating Rate Bond ETF (TFLO) and iShares AAA CLO Active ETF (CLOA) have yields of 4.32% and 5.72%, respectively (see below, as of 1/13/25), with standard deviations of just 0.22% and 0.93%. They have matched or beaten the Aggregate index but with far less volatility.
Excluded securities may offer attractive yields with less risk
Source: Bloomberg as of 1/13/25. Standard deviation uses daily returns from 1/12/23 (common inception)-1/13/25. Yield refers to yield to worst, which is a measure of the lowest possible yield that can be received on a bond with an early retirement provision. Standard deviation measures how dispersed returns are around the average. A higher standard deviation indicates that returns are spread out over a larger range of values and thus, more volatile. Performance data represents past performance and does not guarantee future results. Investment return and principal value will fluctuate with market conditions and may be lower or higher when you sell your shares. Current performance may differ from the performance shown. For most recent month-end performance, standardized performance and to view a prospectus, click the following links: TFLO, CLOA.
While highly rated floating rate debt is the lowest hanging fruit, we see opportunity across many of the plus sectors.
As an example, some of our favorite sectors within the iShares Flexible Income Active ETF (BINC) also include international credit, U.S. high yield and securitized assets.
We believe that an active, diversified approach can monetize these higher-yielding opportunities in a risk-aware way.
BINC currently has a yield-to-worst of 6.23% – more than 100 bps higher than that of the Bloomberg U.S. Aggregate Bond Index – but a standard deviation of just 2.57% since its launch on May 19, 2023. Compare that to the Aggregate Bond Index’s standard deviation of 5.94% over that same period, and the potential benefits of such an approach to these plus sectors become even more clear.6
Building a bond portfolio today
Volatile long bonds. Elevated stock/bond correlations. Investable “plus sector” opportunities.
The combination of all three leads to a bond portfolio that might look different today than it did in prior years. This portfolio might have a shorter duration, with higher yield/income and more plus sector exposure.
As an example, our Target Allocation models team currently splits its 0/100 Hybrid model roughly evenly between core bonds and plus sector bonds. The more you believe that the characteristics of today’s environment will carry forward, though, the more you may want to lean away from long duration and into plus sector exposures.
BlackRock continues to be at the forefront of fixed income investing and we look forward to being a partner of choice for advisors in building portfolios.
To obtain more information on the fund(s) including the Morningstar time period ratings and standardized average annual total returns as of the most recent calendar quarter and current month end, please click on the fund tile.
To view standardized performance for BINC and BSIIX, click on the fund cards above.
The performance quoted represents past performance and does not guarantee future results. Investment returns and principal values may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. All returns assume reinvestment of all dividend and capital gain distributions. Refer to www.blackrock.com or www.ishares.com to obtain performance data current to the most recent month-end.
The Morningstar RatingTM for funds, or "star rating", is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure (excluding any applicable sales charges) that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.
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1 Source: Bloomberg as of 1/16/25.
2 Source: Bloomberg. Past performance is no guarantee of future results. Indexes are unmanaged and one cannot invest directly in an index.
3 Source: Bloomberg, CBO as of 1/14/25.
4 Source: CBO as of 1/14/25.
5 Sources: Morningstar, BlackRock, Aladdin as of 11/30/24. For illustrative purposes only. Analysis based on 22,826 portfolios. These attributes are calculated for each portfolio as a weighted average of the underlying holdings. The portfolio-level metrics are then averaged in each risk profile cohort to arrive at the numbers presented. Allocations are calculated using only models that contain at least one product from that category.
6 Source: Bloomberg as of 1/13/25 based on daily returns from 5/19/23-1/13/25. BINC’s SEC yield is 5.72% and Aggregate Index’s SEC yield is 4.63% as of 1/16/25.
This information must be preceded or accompanied by a current prospectus. Investors should read and consider it carefully before investing.
Investing involves risk, including possible loss of principal.
Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in the value of debt securities. Credit risk refers to the possibility that the debt issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities.
Asset-backed securities are subject to credit, interest rate, call, extension, valuation and liquidity risk and are subject to the risk of default on the underlying asset or mortgage, particularly during periods of economic downturn. Small movements in interest rates may quickly and significantly reduce the value of certain ABS. Mortgage-backed securities ("MBS") and commercial mortgage-backed securities ("CMBS") are subject to prepayment and extension risk and therefore react differently to changes in interest rates than other bonds. Small movements in interest rates may quickly and significantly reduce the value of certain mortgage-backed securities.
Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. The Fund’s income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates. Collateralized Debt Obligations ("CDOs") carry additional risks including, but not limited to: (i) the possibility that distributions from collateral securities will not be adequate to make interest or other payments; (ii) the risk that the collateral may default or decline in value or be downgraded, if rated by a nationally recognized statistical rating organization; (iii) the Fund may invest in tranches of CDOs that are subordinate to other tranches; (iv) the lack of a readily available secondary market for CDOs.
International investing involves risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks often are heightened for investments in emerging/developing markets or in concentrations of single countries.
The Fund's use of derivatives may reduce the Fund's returns and/or increase volatility and subject the Fund to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. The Fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited. There can be no assurance that the Fund's hedging transactions will be effective.
BINC is actively managed and does not seek to replicate the performance of a specified index. The Fund may have a higher portfolio turnover than funds that seek to replicate the performance of an index.
An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency and its return and yield will fluctuate with market conditions.
While the iShares AAA CLO Active ETF (the “Fund”) will invest primarily in CLO tranches that are rated AAA, such ratings do not constitute a guarantee of credit quality and may be downgraded. In stressed market conditions, it is possible that even senior CLO debt tranches could experience losses due to actual or perceived defaults, and rating downgrades and forced liquidations of underlying collateral. CLO securities may be less liquid than other types of securities and there is no guarantee that an active secondary market will exist or be maintained. The CLO securities in which the Fund invests are managed by investment advisers independent of BlackRock Fund Advisors, the Fund’s investment manager, and an affiliate of BlackRock Investments, LLC. Any adverse developments with respect to the CLO manager may adversely impact the CLO securities held within the Fund.
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