Investors keen on locking in the currently attractive yields of US treasuries before the US Federal Reserve (Fed) cuts interest rates in the coming weeks would do well to consider investing in treasury bond exchange-traded funds (ETFs) and investment-grade ETFs, instead of bond funds.

The reason is that fixed income mutual funds or bond funds have historically underperformed their benchmarks due to several factors, including management fees, transaction costs, liquidity issues, and active management decisions.

Treasury bond ETFs and investment-grade ETFs (rated BBB+), like all ETFs in general, mirror their benchmarks, thus eliminating the risk of underperformance. In addition, ETFs are considerably cheaper in terms of investment fees or management fees when compared to bond funds.

“Bond ETFs have several advantages over bond funds. This is because bond ETFs can be subscribed/redeemed like mutual funds and can also be bought and sold on the exchange without touching the underlying bonds," explains Yi Wang, managing director of CSOP Asset Management. "In the case of our 20-year US treasury bond ETF, for example, since this ETF is traded on the Hong Kong Stock Exchange during Hong Kong market hours, investors can position themselves in long-tenor US treasury bonds before same-day key US economic data and monetary policy announcements.”

In addition, pricing of bond ETFs is more transparent since real-time quotes of ETFs on the exchange also help investors in price discovery, unlike in the case of bonds which are traded over-the-counter (OTC). Also, bond ETFs are listed on the exchange, and investors only need stock accounts to trade them, Wang says.

Risk and benefit

With regard to the risk of investing in bond ETFs, he says: “Although the market consensus is that the Fed will start the first rate cut of the new cycle in September, there are still different views on the extent of the rate cut and the number of future rate cuts. Therefore, it may be reflected in the bond ETF in the form of a premium (overbought) or oversold (discount), which may increase the cost of trading.”

Nonetheless, since the liquidity of the bond ETF itself is ultimately determined by the bonds it holds, as long as the underlying bond liquidity is sufficient (such as US treasury bonds), the performance of the bond ETF will not deviate from the underlying bonds even when market fluctuates, Wang says.

“In addition, the mechanism of bond ETFs in dealing with large-scale off-exchange subscriptions and redemptions is very similar to that of bond mutual funds, so the impact of subscriptions and redemptions on the ETF price is very limited,” he adds.

At present, an investor who deploys the “barbell strategy”, which means focusing on the short end (one to three years) and the long end (20-30 years) of the risk spectrum, would benefit from the performance on the short end and from the capital gains from the long end.

Current yields on short-term treasury bills are 4.34% for one year, 3.83% for two years, and 3.72% for three years, while yields for long-term treasury bills are 4.21% for 20 years and 4.13% for 30 years. The short-term yields are generally higher, reflecting the Fed’s recent interest rate hikes aimed at controlling inflation.

“Treasury yields at the shorter end of the curve are poised to decline in response to rate cuts, while longer-maturity yields should come down given a modest slowdown in economic growth – a favourable backdrop for price appreciation in bonds,” says Nuveen chief investment officer Saira Malik.

Data-dependent

The Fed is expected to cut the federal funds rate (FFR) from its current level of 5.255-5.50%, the highest in 23 years, by 25-50bp after achieving some progress in reducing the inflation rate which has dropped to 2.89% in July from 2.97% in the previous month.

“The market expects measured rate Fed cuts, at 25bp per meeting, over the next six months. The pace of rate cuts will be data-dependent and could be more aggressive if the labour market shows further weakness,” says Gary Dugan, chief executive officer of The Global CIO.

Although the inflation rate has dropped closer to the Fed target of 2.0%, it remains to be seen how quickly the Fed will be able achieve this target. Still, Fed chairman Jerome Powell clearly indicated in his speech last week at Jackson Hole, Wyoming, that the US central bank is ready to cut rates in September.

Investing in treasury bond ETFs and investment-grade ETFs at this time is also a way of riding out the current market volatility without too much stress.

“More turbulence may lie ahead, keep your seatbelts fastened,” Malik says. “While the recent market rebound has prompted a sigh of relief, this summer’s volatility serves as a reminder to investors that there’s no vacation from diligently monitoring portfolio allocations.”

Malik argues that there’s still time for investors to add duration and credit exposure to their portfolios with a few weeks to go before the Fed is expected to make its first interest rate cut since 2020.

“The current environment suggests that investors could consider allocating to areas of the market that appear poised for success in a falling rate environment, with the ability to outperform should recessionary conditions emerge. Even as the economy decelerates, consumer balance sheets remain solid, and business investment durable. We believe this combination could help keep corporate default rates low,” she says.