Bond ETF Outflows Suggest Higher Rates Are Starting to Hurt

Bond investors are running from anything that smells of interest-rate risk.

Investors pulled billions of dollars from exchange-traded funds that track longer duration fixed-income plays, as Treasury yields resumed their upward march. In fact, the top four outflows for U.S.-listed ETFs on Tuesday were all fixed-income related, as investors also yanked cash from funds stuffed with junk bonds, according to Christian Fromhertz, chief executive officer of Tribeca Trade Group.

The yield on benchmark 10-year bonds ticked up as high as 3.24% Wednesday, after dripping lower Tuesday in the wake of Monday's holiday. Previously, investors had gotten used to ignoring bump ups in rates, since every time they hit 3 percent, they came back down, said Bloomberg Intelligence ETF analyst Eric Balchunas.

"But this one has broken through, so investors are nervous. This is a sign that investors do not think that rising rates are crying wolf," Balchunas said. "There's less safe spaces where bond ETFs are not negative on the year, and that's why you're seeing more extreme flows. Rising rates have shaken things up for real this time."

The iShares Core U.S. Aggregate Bond ETF, known by its ticker AGG, saw outflows of nearly $2 billion on Tuesday. It was the biggest single outflow in the fund's 15-year history. Investors also pulled close to half a billion dollars from the iShares iBoxx $ Investment Grade Corporate Bond ETF, or LQD.

AGG has about 20% of its underlying exposure to longer-dated bonds that have more than 10-year maturities. LQD has a heftier 38% exposure to that category of debt.

Dumping Junk

The two largest ETFs holding high-yielding bonds also hemorrhaged assets on Tuesday. The SPDR Bloomberg Barclays High Yield Bond ETF, or JNK, saw more than $709 million in outflows, the most since January. The iShares iBoxx High Yield Corporate Bond ETF, or HYG, saw a $809 million outflow, which followed a record $1.2 billion outflow from the fund on Friday.

While the junk bond strategies don't have as much exposure to the longer-duration securities, they still have interest rate risk like any other bond ETF, said Mohit Bajaj, director of exchange-traded funds at WallachBeth Capital.

"The risk/reward just doesn't justify holding these funds," Bajaj said. "The incentive isn't there to continue holdings positions as both equities and bonds sell-off."

On the flip side, ETFs tracking short-term debt lured in flows. The SPDR Bloomberg Barclays 1-3 Month T-Bill ETF, or BIL, saw the eighth-largest amount of inflows among all U.S.-listed funds on Monday. Investors poured $228 million into BIL yesterday, the largest daily inflow in more than 6 months.

Editor's Note: What Do Rising Rates Mean for Life Insurers?

Life and annuity issuers use large amounts of investment-grade bonds to back products that tend to stay in force for a long period of time, or lead to claims or payment streams that last for a long time.

Products that are highly sensitive to changes in interest rates include life insurance, annuities, long-term disability insurance and long-term care insurance.

Products such as major medical insurance, short-term disability insurance, dental insurance and supplemental health benefits tend to be less affected by changes in rates.

Life and annuity issuers try to cope with ups and downs in interest rates by adding interest-rate-linked adjustment features to their products; off-setting sales of interest-sensitive products with sales of other types of products; buying and holding bonds with durations that match the durations of the insurance or annuity liabilities, until the bonds mature; and using derivatives contracts to get investors to take care of some of the interest-rate risk.

Life and annuity issuers generally want to see slow, steady, ongoing increases in rates, to increase yields on the bonds they intend to hold until the bonds mature.

Even those slow, steady increases could cause some headaches for life and annuity issuers: Although insurers try to match asset durations with liability durations, the "asset liability matching" is imperfect.

In some cases, insurers do sell bonds before the bonds mature. For the bonds that may be sold before the maturity date, insurers are hurt as much by rising rates as bond ETF holders are: In that situation, interest rate increases cut how much insurers can get from selling the bonds to other investors.

Life and annuity issuers also have concerns about sharp increases in rates.

For life and annuity issuers, risks from rapidly rising rates include:

The risk policyholders will shift money from insurance-based products to bank certificates of deposit.
The risk that economy as a whole will stall and weaken demand for life and annuity products.
The risk that some previously highly rated corporate bond issuers will fail, and default on their bond payments.

Central bankers try to manage interest rates by adjusting the rates banks themselves pay to borrow money from the central banks. But, among economists, the level of control central bankers have over the rates ordinary companies pay to borrow money is controversial.

—With assistance from Sarah Ponczek and Tom Lagerman.

— Read Buyers Still Like Corporate Bonds, but Companies' Borrowing Costs Are Rising, on ThinkAdvisor.

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