Higher Rates Push Investors to Short and Intermediate Bond Funds

Strap on your hiking boots. 

Investors positioning for the Federal Reserve’s rate hike last week, an attempt to curb inflation exacerbated by rising energy prices due to the Iran war, have moved into short-term bonds. More than $9 billion flowed into short-term government mutual funds and ETFs in August, the second-best month on record after March 2020. 

“Investors are increasingly paying attention to the short end of the yield curve,” said Joe Bullard, a fixed income strategy analyst at Morningstar. “But that’s not to say that the long end has been seeing outflows. Bond flows have been healthy for months across the bulk of categories.” 

A New Old World

The market is in the midst of a transition to a new interest-rate and inflation regime, said Jason Bloom, head of fixed income ETF strategy at Invesco. But actually, this new world is similar to the pre-financial crisis environment. “What it really is, is a transition back to some level of normalcy out of what I called ‘this bizarro quantitative easing world’ that so many people grew up in,” he said. “It’s taken a while for all the participants in the market and for those [pricing] models to consume enough new data to replace all of that contorted, manipulated market data that was the result of the Fed’s artificially suppressing interest rates for the entire decade prior to Covid.” 

Bond mutual fund and ETF flows, per Morningstar: 

• Overall, taxable bond funds brought in $69 billion in August, the fourth consecutive month of inflows above $60 billion.
• Ultrashort bonds were the leading category, with  $15 billion in net inflows, but intermediate core bonds were only $135 million behind. 

Stock Picking for Bonds: Actively managed fixed-income funds are also seeing exponential growth. “In terms of an absolute flow number, passive ETFs have had larger flows than active ETFs, but in terms of a growth rate, active ETFs have definitely been larger than passive,” Bullard said. “Active management in fixed income makes a lot of sense because there’s a lot of inefficiencies within bond indexes.”