Bond investors have spent much of the past several years learning a painful lesson: Bonds can lose money, too. Now, the same dynamics that caused those losses may be reversing to create a potentially much more attractive opportunity.
We know that Treasury yields are back on the rise. The 10-year yield is still up around 4.65% and the 30-year briefly moved above 5.3%, its highest level since 2007. For investors who remember the zero interest rate during much of the 2010s, those yield figures can't be ignored.
Does that mean it's finally time again to buy bond exchange-traded funds (ETFs)? I think the answer is yes. But do you go with corporates, Treasuries, or a mix of both?
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Higher yields have changed the math
The Federal Reserve's aggressive rate-hiking cycle a few years ago created an unprecedented bear market in bonds. The Vanguard Long-Term Treasury ETF (VGLT -0.36%) is still nearly 40% below its all-time high on a total return basis. But the environment today is different.
Even though we may still see a hike from the Fed later this year, we're unlikely to see anything resembling the soaring yields from 2022. Bonds are starting with much higher yields already. If inflation is able to come back down, long-term yields might not get a lot higher than they are currently.
In other words: much better income prospects with substantially lower downside risk. That's suddenly a much more compelling investment option than it was just a few years ago.
NASDAQ: VGLT
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There's still one big risk
This is where things get interesting.
If you're willing to go further out on the yield curve and accept the interest rate volatility that comes with it, you can get a 5.2% yield right now from the Vanguard Long-Term Treasury ETF. But that volatility can be significant. It has a duration of nearly 14 years, which means the share price can be expected to change roughly 14% for every one percentage point move in rates.
A more conservative option, such as the Vanguard Total Bond Market ETF (BND -0.15%) that combines Treasuries and corporate bonds, yields less but has a more moderate risk profile. It pays out about 4.6%, has less than half of the duration risk of the Long-Term Treasury ETF, but it introduces credit risk to the equation.
It really comes down to whether you want the pure interest-rate play of Treasuries or the mixed credit portfolio with more modest rate sensitivity that comes from a total bond market ETF.
NASDAQ: BND
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Which would I buy?
Let's start by profiling the risk/return profiles of each. For the Vanguard Long-Term Treasury ETF, credit risk isn't an issue because these are U.S. government securities. Their return is going to come almost entirely as a result of changes in the yield curve.
If inflation remains elevated or the Fed begins hiking rates, the yield on this ETF is probably going higher. That could result in big losses depending on how far interest rates move. On the other hand, if the U.S. economy begins sliding toward recession, a flight-to-safety trade where demand for Treasuries picks up significantly could result in a 20% gain.
For the Vanguard Total Bond Market ETF, the addition of corporate credit risk could mean added gains in a bull market for bonds. But the much lower rate sensitivity means less upside from that factor. In general, if rates move higher, we're likely to see the share price decline, but maybe not as much as a pure Treasury bond ETF.
For me, I'd prefer the Vanguard Total Bond Market ETF. Long-term Treasuries put virtually all of your risk exposure into rate changes. This ETF, however, broadens out the types of credit you're invested in while lowering rate risk. I think that's the better play at the moment, especially given a strong corporate earnings backdrop.
The Vanguard Long-Term Treasury ETF feels like more of a home run swing: You could score big or lose big. That's not the kind of risk I'd want to be taking.
