The Federal Reserve has been threatening to raise interest rates for a number of months now and ETF investors have opted to call their bluff.  After being burned by the chase for high yield through risky and esoteric asset classes, the focus has now turned towards enthusiasm for plain-vanilla bond funds.

A check of the year-to-date fund flow tracker at ETF.com shows a willingness to gobble up diversified U.S.-focused bond indexes such as the iShares Core U.S. Aggregate Bond ETF (AGG), iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), and Vanguard Total Bond Market ETF (BND).  Together these three funds have accumulated over $12.5 billion in new inflows since the beginning of 2016 and have easily distanced themselves as the top bond ETFs in terms of total size. 

Furthermore, previously beaten down sectors of the fixed-income marketplace such as Treasury Inflation Protected Securities (or TIPs) have garnered greater attention as well.  The iShares TIPS ETF (TIP) has added $2.7 billion in 2016 and become an increasingly popular way to hedge inflation expectations. 

Much of this enthusiasm for historically conservative bond funds can be attributed to one consistent trend: falling interest rates.  Since the beginning of 2016, the CBOE 10-Year Treasury Note Yield (TNX) has tumbled nearly 40% from a starting point of 2.67% to a recent low of 1.61%. 

Part of the fervor exacerbating this movement is the insatiable foreign demand for U.S. Treasury bonds.  A recent Wall Street Journal article cites negative yields and record low interest rates in Japan and Europe as a tremendous catalyst for fixed-income investors seeking better returns.  In fact, a fresh 10-Year U.S. Treasury auction last week recorded record buyers from outside the United States.

The inverse relationship between interest rates and bond prices means that this chase for safety has now turned into a gathering momentum trade.  Rather than face the noticeably greater volatility in stocks, commodities, or even currencies, ETF investors are simply turning to the one asset class that continues to hit new dividend-adjusted highs with little variance in its path. 

In fact, AGG has managed to outstrip the performance of broad stock market indices such as the SPDR S&P 500 ETF (SPY) by a noticeable margin this year.  AGG has gained 4.36% through June 13 versus just 2.77% for SPY. 

The growing question then is just what do investors own in a vehicle like AGG that is taking a more prominent role in many portfolios?

This ETF is comprised of over 5,500 individual fixed-income securities in a passively managed index.  The Barclays Aggregate Bond Index measures the performance of the U.S. investment grade bond market, which includes Treasury bonds, corporate bonds, mortgage debt, and other asset-backed securities.  The asset allocation is structured with a market capitalization weighted focus, which gives prominent positions sizing to Treasury and mortgage-related bonds.

According to iShares.com, AGG has an effective duration of 5.26 years, 30-day SEC yield of 1.91%, and charges a net expense ratio of just 0.08%.  The overall consequence is one that emphasizes safety and quality above yield or specific sector positioning.  Ultimately, this vehicle is one that investors can rely on as a diversified, low-cost, and liquid way to access a broad pool of U.S. bonds. 

However, these same features that make AGG attractive in a falling interest rate environment are also its Achilles heel as interest rates rise.  The assumption for new money into these funds are that the current trend of outperformance and low volatility will continue indefinitely into the future.  This may be a much harder feat to accomplish with Treasury yields now extended to some of their lowest levels in the last decade.

The Bottom Line

Bond funds make up and important role in diversification, risk mitigation, and proper portfolio positioning.  However, just like stocks, they are susceptible to investor sentiment, market psychology, and volatility that can catch many unwary investors off guard. 

Before jumping headlong into this asset class as a presumed measure of safety and income, make sure that the underlying portfolio and interest rate environment aligns with your goals. 

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.