Investors are snapping up corporate bonds, enticed by higher yields and the hope that a soft economic landing means the Federal Reserve will cut interest rates.
Those hopes may well be dashed.
Beginning late last year, investors started to step further out on the yield curve and became more willing to take on credit risk, says Jack Fischer, senior research analyst at LSEG Lipper. As of Feb. 12, net flows into short-intermediate investment-grade debt mutual funds and exchange-traded funds this year were about $20 billion, compared with $50 billion in all of 2023.
“They see the longer-duration aspect of it as being safer now than it was last year,” when investors favored Treasury bond funds, he says. Duration is a measure of interest-rate risk tied to a bond’s or bond fund’s maturity, yield, and other factors.
Steve Laipply, global co-head of fixed-income ETFs at BlackRock, also sees investors gravitating to corporate bonds. The company’s $33.8 billion
iShares iBoxx $ Investment Grade Corporate Bond
ETF (ticker: LQD), its biggest corporate bond fund, saw $2.3 billion in net flows through Feb. 12, about half as much as it received all last year. The buying suggests investors may feel more comfortable with the economic outlook. “Perhaps the hard landing may not come to pass, or if you do see a downturn, it won’t be as severe as once thought,” he says.
The buying spree has lifted prices and lowered yields, bringing them closer to U.S. Treasury yields, but with added credit and duration risk. If the Fed leaves rates higher for longer, or corporate defaults pick up because of a downturn, bond fund holders could see losses.
The historical spread between corporate bonds and Treasuries is about 1.15 percentage points, and currently that spread is around 0.98 percentage points, says Guy LeBas, chief fixed-income strategist at Janney Montgomery. To make corporate bonds worth the higher risk, he’d like to see spreads widen to 1.4 percentage points. “That would get me excited to buy,” he says.
The BlackRock fund has a 30-day SEC yield of 5%, while the $46 billion
Vanguard Intermediate-Term Corporate Bond
ETF (VCIT), another popular fund, yields 5.2%. The $4.7 billion
iShares Core 1-5 Year USD Bond
ETF (ISTB) yields 4.7%.
| Fund / Ticker | SEC Yield | Expense Ratio | Fund Assets (billion) |
|---|---|---|---|
| iShares iBoxx $ Investment Grade Corporate Bond / LQD | 5% | 0.14% | $33.8 |
| Vanguard Intermediate Term Corporate Bond / VCIT | 5.2 | 0.04 | 46.0 |
| VanEck Investment Grade Floating Rate / FLTR | 6.2 | 0.14 | 1.3 |
| VanEck Fallen Angel High Yield Bond / ANGL | 6.6 | 0.35 | 3.1 |
| Nuveen High Yield Municipal Bond / NHMAX | 5.3 | 0.76 | 16.0 |
| iShares Core 1-5 Year USD Bond / ISTB | 4.7 | 0.06 | 4.2 |
Note: Data as of Feb. 12.
Sources: Morningstar, company reports
Phil Kosmala, managing partner at investment consultant Taiber Kosmala, is overweight corporate bonds, but he is also concerned that investors are too optimistic. He expects rates to be higher for longer and thinks there could be a recession later this year.
“Rates are going to stay higher for longer, which means you could clip a really nice coupon without taking a lot of risk staying on the short end of the curve,” he says.
For now, he’s sticking with a fund he has used for a while, the $1.3 billion
VanEck IG Floating Rate
ETF (FLTR), focusing on the 6.2% yield.
The market watchers aren’t completely shunning investment-grade corporate bond funds, they’re just wary, especially since bond funds are currently richly valued. Yields will eventually fall, but they probably won’t decline smoothly, so nimble investors could watch for better prices and more Fed certainty.
High-yield bonds may be worth a look when the outlook for rates is clearer and market sentiment is stable, says John Jones, investment advisor representative at Heritage Financial. He will use a small allocation of high-yield bond funds to boost income and complement Treasury holdings. His preferred funds are the $3.1 billion
VanEck Fallen Angel High Yield Bond
ETF (ANGL), or the $16 billion
Nuveen High Yield Municipal Bond
fund (NHMAX) for tax-sensitive clients.
He’s in the higher-for-longer camp and sees no reason to rush in. “When interest rates get cut, the price of bonds go up, so all those bond funds will appreciate.
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