Overlooked bond market stars may be winners in new Fed policy

  • It's been a blockbuster year for bonds because of the Covid crisis.
  • The muted economic and inflationary environment along with a rush to safety that followed the pandemic was a major tailwind. Long dated bond ETFs like the iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT) are up 20% YTD, up double the S&P 500's 9% over that time.
  • The Fed's decision to target higher inflation announced Thursday could upset that equation, though. Higher inflation could create a major headwind for a bond market with rock bottom yields. The TLT dropped 1.5% for the day on the news, even as broader markets rose.
  • The day's drop comes on the heels of a poor monthly performance for the TLT. Bullish economic developments recently like a resilient consumer sector and strong durable good orders may be raising inflation expectations. The TLT dropped 5% over the month, compared to a 8.4% gain for the S&P 500.
  • While long dated bonds could face headwinds from a more inflationary environment, convertible bonds may continue to thrive if recent history is a guide.
  • Convertible bonds typically provide bond-like benefits to the holder - coupon payments, and seniority to equity holders in the capital structure, for example - but convert to equity to capture upside.
  • The category has already led all others YTD according to the Seeking Alpha bond ETF tracker. But it has also advanced over the last month when the TLT tumbled.

  • Popular convertible bond ETFs include the SPDR Series Trust Convertible Securities ETF (NYSEARCA:CWB) and the iShares Convertible Bond ETF (BATS:ICVT). They are up 27% and 31% YTD, far ahead of the TLT and the S&P 500.
  • The CWB is far larger and more liquid than the ICVT.

  • But both are small compared to widely-held bond ETFs. The iShares Core US Aggregate Bond ETF (NYSEARCA:AGG) has an AUM of $79B, while the Vanguard Total Bond Market ETF has an AUM of $52B for example. The TLT has an AUM of $19B.
  • And while the ICVT has outperformed the CWB YTD, both have managed to thrive over the last month where the TLT struggled.

  • The equity-like nature of convertible bonds could be allowing them to thrive and follow equities up even as long bonds struggle.
  • Both ETFs also count convertible bond issued by companies with strong recent returns like Tesla (NASDAQ:TSLA) as their top holdings, which could further be boosting returns.
  • CWB:

  • ICVT:

  • Both have also managed to rally previously in rising rate environments that have pressured the TLT, like 2018.

  • Not all bonds are created the same, then. And already leading the booming fixed income segment YTD, convertible bonds could thrive still if rates were to move higher under the Fed's new regime.
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