Investors Eye Fed, But Bond ETFs Still Add Assets

The Federal Reserve raised interest rates in March, marking the third time in 15 months the U.S. central bank nudged borrowing costs higher. Following the March rate hike, conventional wisdom dictated that one or more rate hikes were coming this year.

With economic growth solid but not spectacular and lingering concerns about Trump administration efforts on tax reform, among other issues, the Fed may not have the leeway to raise rates it had just a few months ago. What has been consistent has been investors' affinity for fixed income exchange-traded funds in 2017.

Two of this year's top 10 ETFs in terms of new assets added are corporate bond funds, and investors have remained loyal to Treasury ETFs even with all the talk of higher interest rates. For example, the iShares 20+ Year Treasury Bond ETF (NYSE:TLT) has added more than $1.3 billion in new assets this year while the iShares 7-10 Year Treasury Bond ETF (NYSE:IEF) has seen inflows of nearly $116 million.

Explaining The Phenomenon

There are obvious reasons why U.S. government debt and the related ETFs continue attracting investors' dollars.

While U.S. investors, particularly those dependent on income, bemoan the lack of yield, pity the investor in Europe or Japan. German 10-year yields are still below 0.50 percent, while similar maturities in Japan and Switzerland yield 0.03 percent and -0.09 percent respectively, said BlackRock in a recent note. With the exception of Australia and New Zealand, the U.S. has just about the highest long-term rates in the developed world. For many foreign investors, the U.S. remains an attractive place to invest, keeping bond prices high and yields suppressed.

The $6.6 billion, which holds Treasuries with maturities of 20 years and up, has an effective duration of 17.3 percent. That means the ETF is highly sensitive to changes in interest rates, but investors are compensated for that rate risk with a yield of almost 2.8 percent. Good luck finding that on German bunds or Japanese government bonds (JGBs).

The $7.7 billion IEF, which tracks the ICE U.S. Treasury 7-10 Year Bond Index, has an effective duration of 7.5 years and a 30-day SEC yield of almost 2.1 percent. Again, that is better than what investors will find on most ex-U.S. developed market sovereign debt.

The Fed is likely to continue to lift short-term rates while increasing tightness in labor markets should nudge wages higher, said BlackRock. That said, it is not obvious that the secular factors that have been suppressing bond yieldsslow nominal gross domestic product, demographics, regulatory pressure and even lower yields outside the United Statesallow for a melt-up in rates. When we look back on 2017, we may very well see another year in which rates defied expectations.

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