Bond ETF Investors Face Increased Risks in a Lower-For-Longer Rate Environment | ETF Trends

In an ongoing depressed interest rate environment with an influx of debt issued by companies seeking capitalize on the cheap loans, bond ETF investors are exposed to greater risks.

According to Boston-based fund manager GMO, the surge in U.S. bond prices and record low yields have increased the risk of losses for investors in funds that track the benchmark U.S. Aggregate Bond Index, such as the popular iShares Core U.S. Aggregate Bond ETF (NYSEArca: AGG).

Yields on benchmark 10-year Treasury notes dipped to 1.38% on Monday or just shy of its record low while U.S. investment-grade bonds are also showing yields at around record lows as well.

Meanwhile, yields on the benchmark “Agg” have dipped to, and investors are now exposed to a significant increase in duration or sensitivity to changes in interest rates. The iShares Core U.S. Aggregate Bond ETF already comes with a 5.64 year duration and a low 2.02% 30-day SEC yield.

“The Agg is a portfolio that has turned prudence on its head,” Peter Chiappinelli, a member of GMO’s asset allocation team, told the Financial Times.

Meanwhile, the lower-for-longer interest rate environment has pushed more companies to issue debt as a way to capitalize on cheaper loans. US companies have accumulated a massive debt load that has surpassed $13.6tn over the past decade, according to the Securities Industry and Financial Markets Association.

Furthermore, the rise in debt has also fallen in quality, with more than half of the corporate bonds held by the Agg rated as BBB at a time when US companies’ capacity to service their debt from earnings weakened.

Some observers warned that real yield, or yields after taking inflation into account, of the Agg is close to zero while future returns are expected to be lower than those achieved historically after a three-decade long bull rally in bonds.

“The Agg offers some of the lowest expected returns in its history,” Chiappinelli added.

Looking ahead, BlackRock also projects the Agg to deliver annualized returns of 1.8% over the next decade. In comparison, the AGG ETF generated an average annualized return of 3.8% over the past 10-years.

Nevertheless, while there are risks, bond exposure still provides some stabilizing effect for a diversified portfolio, especially during more volatile conditions.

“Expected returns for fixed income are modest, but this makes it all the more important to remember why you hold bonds in a portfolio in the first place – as ballast for portfolio’s equity risk. This hasn’t changed,” Josh Barrickman, Americas head of fixed income indexing at Vanguard, told FT.

For more information on the fixed-income markets, visit our bond ETFs category.