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2 Bond ETFs for a Rising Interest-Rate Environment

Now may be the time to tweak your fixed-income holdings.

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. The Federal Reserve has indicated that it will begin raising interest rates this year. Joining me today to discuss what that may mean for investors in bond ETFs is Ben Johnson. Ben is Morningstar's director of global ETF research.

Hi, Ben. Good to see you.

Ben Johnson: Hi, Susan. Great to see you.

Dziubinski: Let's start off with a little bit of a backdrop of what's been going on in the bond market so far this year.

Johnson: Susan, as you alluded to, the Fed has telegraphed its intentions to the market. It's indicated that it's going to begin to increase interest rates in March. It's going to pare back its bond-buying activity. The markets responded. Yields have gone higher. Bond prices have gone lower as a result. And if you look at where we stand on a year-to-date basis as of Feb. 22, the Morningstar US Core Bond Index was down 3.9% on a year-to-date basis. That's after it slipped 1.6% in 2021.

Dziubinski: So, then, how have bond-focused ETFs in particular done?

Johnson: The short answer to that question, Susan, is: It depends. If you look at the 535 bond ETFs that exist in Morningstar's U.S. funds database, what you see is that the median return on a year-to-date basis among those funds is minus 3.4%, so about in line with the broad market. But if you take a step back and you look at the spread of performance among those 535 funds, the difference between the year-to-date returns for the best-performing bond ETF and the worst-performing bond ETF is nearly 29 percentage points. So, not all bond ETFs--it should be painfully obvious--are created equal. And what we've seen in terms of how investors have responded is that for the year-to-date they've withdrawn collectively $2.25 billion from fixed-income ETFs. But that said, it's not as though they haven't been allocating at all to fixed-income ETFs. So, among those ETFs that have seen inflows on a year-to-date basis, collective inflows into those funds have amounted to $36 billion. So, there's some withdrawal going on, broadly, from the category, but there's also some fresh decisions being made at the margin. There's a redirection of some flows. Some of what we've seen in terms of flow activity remains steady as ever. So, ongoing inflows into broadly diversified core bond funds--like the iShares Universal Core Bond ETF (IUSB), the Vanguard Total Bond Market ETF (BND) continuing to gain new flows, likely coming from long-term allocators. Slightly beneath the surface you see a reallocation away from longer-dated bonds in particular to shorter-dated bonds that face less interest-rate risk as investors position themselves for an expectation that rates are going to rise at least through 2022 if not beyond.

Dziubinski: Given these expectations, Ben, about interest-rate increases, is it those shorter-term bond ETFs that will more than likely hold up better than others? What should investors be thinking about there?

Johnson: That's absolutely the case. The less interest-rate risk, the better, in a rising-rate environment, generally speaking, which is why we've seen, at the margin, much new money that is indeed continuing to go into fixed-income ETFs going into those ETFs that focus on the shorter end of the yield curve. We've also seen fresh flows--a spike in flows, really--into other categories that help investors position themselves for the potential for rising rates, specifically within the bank-loan category, which has gotten a fresh wave of inflows across both ETFs and mutual funds from investors in recent months. Those loans have rates, generally speaking, that tend to reset with rises in interest rates, and as a result, their interest-rate risk is really de minimis. The rates will tend to rise subject to certain constraints alongside rises in key interest rates. So, anytime you see the prospect of rising rates looming on the horizon, it's a little surprise that you see investors flock, in this instance, en masse to bank-loan ETFs and in bank-loan mutual funds more generally.

Dziubinski: So, then, lastly, Ben, given this backdrop of rising rates, do you have a couple of ETFs that investors might consider today for those portfolio roles in their portfolio?

Johnson: There's a pair of sibling ETFs that have been longtime favorites of ours, both of which are actually actively managed. That's the Pimco Enhanced Short Maturity ETF. The ticker for that fund is (MINT). And its close cousin and more recent entrant into the space, its ESG-intentional variant, the ticker for that fund is (EMNT). Both of these funds receive a Morningstar Analyst Rating of Gold, and that rating is based on a solid parent firm in Pimco, a solid team, great people behind this portfolio, and Jerome Schneider and team, who have helmed this fund, in the case of MINT, since its inception, have done so capably, have delivered terrific performance for investors, both relative to the category and the category index. And we have confidence that they will continue to do so well into the future.

Dziubinski: Ben, thank you so much for your perspective on the bond market today and giving us a couple of ideas that we might turn to for our bond allocations. We appreciate it.

Johnson: Thank you again for having me, Susan.

Dziubinski: I'm Susan Dziubinski for Morningstar. Thanks for tuning in.



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Ben Johnson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.