The Fed’s top economists reversed previous recession predictions. The stock market, measured by the S&P 500, is up nearly 20% since January. Critically, we’re less than 5% below the mid-pandemic market high in a very different economic landscape. Rates are at their highest point in 22 years, and inflation, though well below the recent 9% high, is still higher than we’ve seen in over a decade. This has led to the rise of bond ETFs.
With these seemingly-bearish economic indicators, the market’s recent resurgence must be due to fundamental strength, right? After all, we’ve (maybe) achieved Powell’s promised soft landing, so it’s safe to assume it’s all roses from here.
Not so fast.
Plenty of economic indicators show that, despite a sharp market reversal, we may see darker days ahead before the sun truly rises. Inflation is still one-third higher than the Fed’s target rate, and some claim inflation reports are artificially low as it includes two categories skewing the stat: food and fuel. Omit these two categories, as many economists prefer based on pricing volatility, and core inflation is closer to 6% and higher than we’ve seen since 1980.
So, what should nervous or skeptical investors do? Stocks are arguably back to being overvalued as the market-wide average P/E ratio is back in the 20s. Although savings account yields are higher than they’ve been in years, recent banking collapses may scare investors from staking substantial cash in an account. Likewise, some investors avoid high-yield bond laddering strategies due to secondary market liquidity concerns (the best pricing usually goes to those with hundreds of thousands of dollars worth of Treasuries to buy and sell).
There are, however, some liquid and viable alternatives for market-shy, risk-averse investors who nevertheless want to squeeze some yield from their investments: bond ETFs.
iShares 0-5 Year High Yield Corporate Bond ETF (SHYG)
Expense ratio: 0.30%, or $30 annually on a $10,000 investment.
Of all bond ETFs best for nervous investors, the iShares 0-5 Year High Yield Corporate Bond ETF (NYSEARCA: SHYG) is my preferred pick. The ETF balances bond stability with a great yield and has the potential to jump considerably in price once rates flatline (or if the Fed cuts them at any point in the near future).
SHYG bundles non-investment grade corporate bonds, also known as high-yield or junk bonds. Corporate giants and mainstays you likely know issue these bonds, including American Airlines (NASDAQ:AAL) and Uber (NYSE:UBER). Although the bonds are deemed junk due to higher default risk, packaging many bonds lets investors diversify the risk of one firm defaulting.
At the same time, firms issuing junk bonds must offer higher yields than competitive products to attract investors. These companies have a high bar to hurdle in a high-rate environment, where even savings accounts yield 4% or more. That’s why SHYG’s current yield is a whopping 8%. This rising rate far outperforms Treasuries and money market funds today.
Finally, remember that bond prices and yields are inverse: as yields rise, prices fall, and vice versa. If rates are likely to fall in the future or remain flat for a lengthy period, today’s bonds are worth more than those issued tomorrow, and the price rises in turn.
SHYG’s short-term holdings compete with Treasuries of equivalent maturity, and today, the Treasury yield curve is inverted. This means short-term Treasuries yield more than long-term equivalents. Eventually, the curve will reorient, and short-term yields will fall – pushing prices higher. Current bond prices will rise as these yields fall, and, for a period, the bond ETF’s price will rise as well. This capital gain rewards early investors, who effectively “double dip” by enjoying high-yield monthly returns.
iShares 0-5 Year TIPS Bond ETF (STIP)
Expense ratio: 0.19%, or $19 annually on a $10,000 investment.
Treasury inflation-protected securities, shortened to TIPS, help investors buffer inflation’s effects. These assets usually offer a fixed coupon (interest rate), but the value fluctuates based on inflation. So, if the security yields 5% on a $100 face value and inflation jumps 5%, the face value rises to $105.
TIPS had a weird year in 2022. Although inflation skyrocketed, the Fed’s rapid rate hikes forced bond prices downward. Ultimately, TIPS’ inflation defense couldn’t keep track, and the iShares 0-5 Year TIPS Bond ETF (NYSEARCA:STIP) fell nearly 10%. Today, though, inflation remains elevated but the Fed’s increasingly dovish (for now). The prospect of fewer or reduced rate hikes bodes well for this bond ETF.
Ultimately, STIP will maintain its inflation-influenced high yield, but the prospect of rate stagnation means bond pricing should rise over the coming months as the Fed slows or settles its pace in Fall, as many expect. STIP currently yields more than 8% while the stock remains near its one-year low.
Ultimately, the STIP thesis mirrors SHYG – but with a crucial difference. STIP is built on the back of government-issued securities. This means the underlying bonds aren’t exposed to as much credit risk as junk bond ETFs. This makes SHYG and STIP a risk-diversified complementary pair in a nervous investor’s portfolio.
SPDR 1-3 Month T-Bill (BIL)
Expense ratio: 0.135%, or $13.5 annually on a $10,000 investment.
Finally, the SPDR 1-3 Month T-Bill (NYSEARCA: BIL) ETF is best for the most nervous investors who want to avoid equities and generate as much yield as possible but prefer avoiding savings accounts or dealing with the hassle of laddering Treasury bills on their own. As the name implies, BIL holds a basket of the shortest-term Treasuries, with three months as the upper limit. As long as the yield curve remains inverted, BIL will generate a decent yield. True to form, its current SEC yield is more than 5%, paid monthly.
Realistically, BIL is best used as a place to park cash rather than a long-term investment. BIL won’t likely see the same capital appreciation as SHYG or STIP as the ultra-short maturity window keeps pricing consistent. The ETF’s standard deviation is a remarkably-low 0.53, indicating almost no pricing volatility. In comparison, the SPDR S&P 500 ETF’s (NYSEARCA:SPY) standard deviation is 18.16 and SHYG’s is 6.2.
If daily market moves make you sick but don’t trust the Fed’s flat outlook, you might prefer BIL to other bond ETFs to stash spare change.
On the date of publication, Jeremy Flint held a long position in SHYG. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
