Futu Research | ETF Investment Research
[US Bond ETF] Measuring the expected change in interest rates, which US bond ETFs are worth watching?
Since this year, the movement of the US stock market has been significantly driven by the market's expectation of a cut in interest rates from the Federal Reserve. Following the conclusion of the Federal Open Market Committee (FOMC) meeting on March 21 at the beginning of the year, the Fed formally announced that it would keep interest rates unchanged, releasing potential signals to markets that three rate cuts could take place during the year.
However, as the middle of the year approaches, the fall in interest rates has not reached any substantive ground. Several Fed officials spoke this week suggesting that the Fed needs more time to assess inflation data before lowering interest rates from current levels: According to a disclosure on the U.S. Department of Commerce website, the U.S. Quarterly Total Personal Consumption Expenditure (PCE) price index rose by 3.4% year-on-year, for the fourth time last year The quarter was 1.8%; the Core Personal Expenditure Price Index rose 3.7% with a prior value of 2.0%, exceeding market expectations.
The next Fed meeting will be held from June 11 to June 12, local time, and the latest Economic Forecast Summary (SEP) and bitmap will be published. Notably, the benchmark 10-year bond yield, which is risk-free, fell to 4.41% from 4.68% at the end of April. If the Fed is able to push through the rate cuts this year, there will be a marked improvement in the debt market, which has been shrouded in the glow of the stock market during the previous rate hike cycle.
Relationship between falling interest rates and bond prices
Imagine that you have a loan in your hand, which is like a bond, on which it says that someone has lent you 100 pieces of money and promises to give you a certain interest every year. Now that borrowing rates have decreased throughout the market, which means that now someone else just has to pay a lower interest rate than before if they want to borrow money.
That way, the bond that you had promised to give you a higher interest rate becomes a real bargain. Because your bonds are more profitable than newly issued, lower-interest bonds. So if someone else wants to get that income, they're willing to pay more than the bond's face value to buy your bond, causing the price of the bond to rise.
For longer-term loans, those bonds that take longer to mature are more sensitive to changes in interest rates. When interest rates fall, long-term bond price increases are usually greater. This is because for long-term bondholders, the future cash flow gains brought about by targeting a relatively high fixed interest rate are more significant, making investors more willing to buy longer-term bonds at higher prices, further pushing their market prices higher.
In general, the price of bonds increases when interest rates fall, and the longer the maturity of bonds becomes more variable.
Previously, US Treasury prices have fallen to relatively low positions due to continued interest rate hikes by the Federal Reserve. If the future Fed successfully enters a rate reduction cycle, overall market interest rates will fall, followed by lower yields on newly issued bonds. As a result, the relatively high yield of old bonds in the past instantly turned into a quagmire, and investors sought these bonds that were able to lock in higher yields, driving the price of bonds back up.
At the same time the Fed cuts interest rates, yields on long-term bonds tend to go down, which is like telling everyone that the future economy may be less optimistic, and longer-term bonds as a relatively safe investment grade are more popular at lower rates. Therefore, once the policy of lowering interest rates is really in place, we can expect a wave of bullish sentiment in Treasury prices.
Which Bond ETFs to Choose
Direct Investment Bonds vs Investment Bonds ETFs
For the average investor, investing in bond ETFs will be somewhat more convenient. The biggest advantage of bond ETFs is that investors can avoid the hassle of choosing specific bonds and directly hold a basket of bonds at low cost to achieve the purpose of diversifying investments.
Bonds and ETFs are essentially two completely different trading categories, buying a bond can hold maturity, but an ETF is essentially a fund and there is no “maturity” so what to do when the bond that holds the ETF expires? Actually you don't need to worry about this at all:
Let's say you buy an ETF that invests in U.S. Treasury bonds over 20 years, every once in a while, the ETF issuer checks its holdings, sells some bonds with less than 20 years of “shelf life” and swaps them into new ones.
Based on this characteristic, the interest rate uncertainty faced by bond ETFs is relatively greater. However, if the purpose of investing in a bond is only for a stable interest rate, then you can still hold the maturity and changes in interest rates will not have an impact.
In addition to the two points mentioned above, there is a difference between the two:
1. Dividends are different; investment bonds typically pay 1~2 times a year, investment bond ETFs typically pay monthly;
2. Trading threshold requirements and fees are different; investment bond fees include commissions, custodial fees, etc. The fees for investing in bond ETFs are the same as those for trading stocks, and an administration fee is required.
However, due to the characteristics of this type of investment, bonds or bond ETFs are suitable for long line investments and not for frequent short term trading (except for leveraged and reverse ETFs).
Specific US Bond ETF Classification
U.S. Treasury Bonds:
1. $iShares 20+ Year Treasury Bond ETF(TLT.US)$: TLT is an ETF that tracks long-term US Treasury performance, primarily investing in US government bonds with outstanding maturities of more than 20 years. As a long-term Treasury ETF, TLT yields are closely related to long-term interest rate movements and generally perform well in the event of rising market risk-averse sentiment or anticipated future rate declines. It provides an effective tool for long-term interest rate risk exposure for investors looking for stable cash flows and hedged asset allocations.
Advantages: High liquidity provides investors with a simple and effective way to get returns in the long-term US bond market, while having low relevance, which helps diversify portfolios.
2. $SPDR Bloomberg Barclays 1-3 Month T-Bill ETF(BIL.US)$: BIL IS AN ETF THAT TRACKS SHORT-TERM U.S. BOND INDEX PERFORMANCE, PRIMARILY INVESTED IN U.S. GOVERNMENT-ISSUED BONDS WITH A REMAINING MATURITY OF NO MORE THAN 1 YEAR. Because its benchmark is short-term Treasury bonds, BIL has relatively low volatility and can be used as a configuration option as a cash management tool or as a lower-risk part of a portfolio.
Advantages: Low risk, low volatility, stable returns for investors and high liquidity.
Disadvantages: Compared to long-term bonds, short-term bonds have limited capital appreciation when interest rates are lowered, so higher total returns may not be obtained.
3. $iShares U.S. Treasury Bond ETF(GOVT.US)$: GOVT IS AN ETF THAT COVERS ALL TYPES OF MATURITY BONDS ACROSS THE ENTIRE U.S. BOND CURVE, DESIGNED TO REFLECT THE OVERALL PERFORMANCE OF THE U.S. BOND MARKET. BY INVESTING IN TREASURY BONDS WITH DIFFERENT MATURITIES, THE GOVT IS ABLE TO PROVIDE INVESTORS WITH COMPREHENSIVE RISK EXPOSURE TO THE U.S. BOND MARKET, EFFECTIVELY DISPERSING TERM RISK.
Advantages: The diversification of Treasury term investments is a good choice for investors who want to participate in the entire US bond market and manage risk.
Disadvantages: Due to the inclusion of various maturity bonds, their yield performance is influenced by the market's demand for different maturity bonds, unlike the strategy of a single term Treasury ETF is clear.
4th. $iShares 7-10 Year Treasury Bond ETF(IEF.US)$: IEF is an ETF that tracks mid-term U.S. Treasury indexes and invests in U.S. Government bonds with a remaining maturity of 7 to 10 years. Compared to long-term Treasury ETFs such as the TLT, IEF is moderately affected by interest rate movements, with some room to increase yields and some degree of hedge against interest rate risks.
Advantage: Medium-term Treasury ETFs strike a balance between yield and safety, especially for investment configurations when the interest rate outlook is uncertain.
Disadvantages: In an extreme interest rate environment, whether rapidly rising or falling sharply, it may not perform well with ETF products that specifically bet on the long-term direction of interest rates.
5. $Short-Treasury Bond Ishares(SHV.US)$: SHV IS ALSO A SHORT-TERM U.S. TREASURY ETF THAT INVESTS IN U.S. GOVERNMENT BONDS WITH AN AVERAGE REMAINING MATURITY OF LESS THAN 1 YEAR. SHVs are ultra-short-term bond funds with virtually no credit risk and extremely low correlation to interest rate volatility. They are a good cash management tool and a safe haven asset.
Advantages: Extremely low volatility and risk, especially as a haven for capital during market volatility.
Disadvantages: Lower potential returns and cannot bring significant capital gains to investors.
6. $Schwab Strategic Tr Intermediate-Term Us Treasury Etf(SCHR.US)$: SCHR IS A SHORT-TERM U.S. TREASURY ETF OFFERED BY CHIACIN BANKING THAT INVESTS IN U.S. TREASURY BONDS THAT ARE LESS THAN ONE YEAR AT MATURITY. The ETF aims to provide returns close to those of money market funds while maintaining higher liquidity than money market funds.
Advantages: Extremely low level of risk, high liquidity, and relatively stable returns are ideal tools for short-term asset hedging.
Disadvantages: During a rising interest rate cycle, its earnings growth is slower and may be lower than some slightly riskier fixed income products.
U.S. Municipal Debt:
7. $S&P National Amt-Free Muni Bd Ishares(MUB.US)$: MUB is an ETF focused on the U.S. municipal bond market that invests in tax-free state and local municipal bonds. These bonds are typically used to fund public works and infrastructure, and interest income is exempt from federal income tax for qualifying investors.
Advantages: For investors seeking a stable income and looking to reduce their taxable income burden, MUB is an ideal choice, especially under higher marginal tax rates.
Disadvantages: Although the credit risk of municipal bonds is relatively low, it is not absolutely zero risk, and there is still the possibility of default on individual municipal projects. In addition, the tax advantage may weaken if investors are not required to pay federal income tax or lower tax rates.
Corporate Debt:
8. $Ishares Iboxx $ Investment Grade Corporate Bond Etf(LQD.US)$: LQD is an investment-grade corporate bond ETF that tracks the performance of the iBoxx USD investment-grade corporate bond index. The ETF holds the bonds of large, reputable companies, which often have solid finances and high credit ratings, providing investors with a relatively stable and higher-yielding investment channel than government bonds.
Advantages: Because of investing in investment-grade corporate bonds, LQDs are less risky than high-yield bonds, but still provide a certain level of return. It is a suitable tool for investors looking for fixed income enhancement and moderate risk exposure.
Disadvantages: Although credit risks are relatively low, an economic downturn or worsening of individual companies' financial situation may result in credit downgrades, affecting the performance of LQD. In addition, the credit risk of corporate bonds is always present compared to government bonds.
9. $Ishares Iboxx $ High Yield Corporate Bond Etf(HYG.US)$: HYG is a high-yield corporate bond ETF that invests in the non-investment grade or “junk bond” market. These bonds typically come from companies with lower credit ratings, but they offer higher box office rates to attract investors.
Advantages: HYG provides investors with higher yield potential from investment-grade bonds, which can be an important source of increased portfolio returns, especially in a low interest rate environment.
Disadvantages: High yield bonds have a higher credit risk, and the risk of default increases significantly, especially during economic downturns. In addition, volatility is relatively high due to its price sensitivity to market sentiment and interest rate changes. Under adverse conditions, the value of such bonds may shrink significantly.
Tax issues
Non-US tax resident investors are not subject to capital gains tax levied by the US. If non-US tax resident investors directly hold US bonds, whether US Treasury bonds, local government bonds, or ordinary corporate bonds, there is no interest tax.
However, if it is a US bond held through a bond fund or bond ETF, the interest paid by that fund or ETF is treated as dividends and is subject to tax at the rate of the dividend tax.
The tax situation of the herd and the tax refund operation of Futubull can be seen in the following official tutorial:ETF Tax Refund Guide: Know Your Investment Returns
