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The Federal Reserve’s monetary policy set the tone for the fixed income world in 2023 – right down to which exchange traded funds investors picked to take advantage of higher interest rates. The central bank’s rate-hiking campaign, which began in March 2022, resulted in the benchmark fed funds rate reaching a range of 5.25% to 5.5% in July 2023. Investors snapped up certificates of deposit, which were touting annual percentage yields of more than 5% on one-year instruments. They also stashed money into money market funds and Treasury bills and nabbed similarly sweet yields. Fixed income ETFs also grabbed a healthy amount of investors’ dollars. And investors didn’t have to take all that much risk to generate income. In all, investors poured roughly $210 billion into fixed income ETFs last year, with $24 billion flowing into these funds in December alone, according to data from Bloomberg Finance and State Street Global Advisors. “It’s really just one simple reason in my opinion why you’ve seen inflows into bond funds, and it’s simply yield,” said Paul Olmsted, senior manager research analyst, fixed income at Morningstar. “We haven’t seen yields like this since 2008.” Bond yields have an inverse relationship to their prices, so that when prices decline, yields rise and vice versa. Fed policy and the pursuit of yield “For the first eight months of the year, it was this ‘higher for longer’ notion, and it really accelerated interest in the ultrashort government bond space,” said Matthew Bartolini, head of SPDR Americas Research at State Street Global Advisors. Investors were also skittish of going too far out on the yield curve – as longer-dated issues tend to be more price sensitive to changes in interest rates – following 2022’s steep rise in bond yields and sharp price declines to match. “Investors preferred not to take on a lot of interest rate risk, especially coming off of 2022 when long-term yields rose so quickly that you saw some double-digit negative returns in core bonds,” said Olmsted. An inverted yield curve offering higher short-term rates than long-term rates helped make up investors’ minds too. “That’s compelling: Higher yield in short duration versus intermediate or long. That dynamic was in play,” Olmsted added. To that end, investors poured more than $41 billion into ETFs containing short-term government bonds in 2023, according to data from Bloomberg Finance and State Street. So-called ultrashort bond funds that were favored by investors included the iShares 0-3 Month Treasury Bond ETF (SGOV) , which scooped up more than $11 billion in flows last year, according to Morningstar. The SPDR Bloomberg 1-3 Month T-bill ETF (BIL) , another way to get exposure to Treasury bills, garnered $6.7 billion in flows in 2023. SGOV offers a 30-day SEC yield of 5.39%, compared to BIL’s 5.20%. Investors playing the short end of the curve also leapt into the iShares Treasury Floating Rate Bond ETF (TFLO ), adding more than $6 billion to the fund last year, Morningstar found. Treasury floating rate notes are issued by the federal government and have an interest rate that can change over time. Though Treasury bills, notes and bonds, as well as floating rate notes can be purchased via the federal government’s TreasuryDirect website, investors may prefer to buy them in an ETF due to their liquidity and the ease of recordkeeping alongside the rest of their portfolio. Longer-dated plays Investors’ whims changed as 2023 wound down. For starters, the Fed held off on hiking rates in its final three meetings of the year. Central bank policymakers also penciled in a trio of rate cuts in 2024. This bet that rates would come down – and bond prices would rise – made longer-dated issues and the funds holding them more attractive. That factor may have contributed to the $24.8 billion in net flows into the iShares 20+ Year Treasury Bond ETF (TLT) last year, according to Morningstar. The fund, which has a 30-day SEC yield of 4.17%, has an effective duration of nearly 17 years – meaning its swings in price can be volatile versus fluctuations in rates. It was also the fixed income ETF in Morningstar’s universe that attracted more money than any other in 2023. “It’s a speculative play there,” said Olmsted. “The thought that long-term yields would fall. People thought that was probably a good risk-adjusted trade.” “I would argue that it’s so hard to predict how interest rates go, that it’s probably not an appropriate trade for a lot of people,” he added. The Vanguard Long-Term Treasury ETF (VGLT) was another favorite of investors, with about $7.3 billion in net flows in 2023. The fund has a 30-day SEC yield of 4.25% and an average duration of 15.2 years. Adding some duration As compelling as it may have been for investors to chase yields on the short end of the yield curve and hope for price appreciation on the long end, a measured approach to picking bond exposure is the best bet. “I would be cautious about taking this short-term approach to investing, especially in the bond market,” said Olmsted. He noted that diversification will be “incredibly important this year.” That’s where core bond funds come into play. Indeed, select core bonds held their own during the 2008 and 2020 recessions. Features that contribute to their success include intermediate duration and diversification across Treasurys, corporate bonds and mortgage-backed securities. Indeed, those strategies proved popular with investors in 2023, as the Vanguard Total Bond Market ETF (BND) and iShares Core U.S. Aggregate Bond ETF (AGG) were ETFs with the second and third highest net flows, per Morningstar. BND picked up $22.9 billion in estimated net flows, while AGG grabbed $16.7 billion, the research firm found. “I think investors should prefer the intermediate portion of the yield curve; it’s a better risk-adjusted trade in the long run,” said Olmsted.
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