Here’s where ETF investors could turn to hide as Treasurys sell-off upends U.S. stocks

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A renewed rout in the U.S. government bond markets that sent the yield on the 10-year Treasury bond to 16-year highs as a new era of higher-for-longer interest rates takes hold, is leaving ETF investors scrambling for the exits on a wide range of exchange-traded funds in the past week, most notably the iShares 20+ Year Treasury Bond ETF
TLT.
 

TLT, one of the most popular fixed-income ETFs that tracks a market-weighted index of the U.S. Treasury bonds with maturities of 20 years or more, earlier this week suffered its lowest close since the early days of the 2007-2009 financial crisis. The yield on the 10-year Treasury 
BX:TMUBMUSD10Y
slipped 2 basis points to 4.715% on Thursday, after reaching 4.801% on Tuesday, its highest closing level since Aug. 8, 2007, according to Dow Jones Market Data.

See: Bond investors feel the heat as popular fixed-income ETF suffers lowest close since 2007

The bond market, particularly the U.S. Treasury market, has historically been less volatile and and has often performed better than other financial assets during economic slowdowns. However, that doesn’t mean bonds don’t come without their own risks.

Rising yields reflect a diminishing price for the securities when interest rates rise, and hit existing holders of Treasuries.

See: Rising Treasury yields are upsetting financial markets. Here’s why.

The surprising strength of the U.S. economy, as demonstrated by this week’s labor-market data, coupled with hawkish talk from Federal Reserve officials indicating the central bank may need to keep tightening monetary policy, have led to the bond sell-off this week.

Meanwhile, a positive Treasury term premium, or the compensation that investors require for the risk of holding a Treasury to maturity, have also contributed to a steep sell-off as a ballooning U.S. budget deficit and the Treasury’s need to issue more debt have pushed Treasury prices to 16-year lows.

TLT
TLT
has fallen over 50% since its peak in August 2020, according to FactSet data. The losses are “pretty much” what the equity-market loss was from peak to trough during the global financial crisis, said Tim Urbanowicz, head of research and investment strategy at Innovator ETFs. 

“It is not insignificant… It really makes you think about how you’re doing risk management because you can’t have the piece of the portfolio that’s supposed to be the risk mitigator falling the worst we’ve ever seen in the equity-market fall. That’s a big issue,” Urbanowicz told MarketWatch. 

That’s why ETF investors have very few options when developing or adjusting their asset allocation play in the higher-for-longer rates environment, but there are still some shockproof assets for safety, according to ETF strategists. 

Ultra short-term bond funds 

ETF investors that still favor bonds can consider hiding in ultra short-term bond funds to avoid duration risk as the Fed may still need to raise interest rates to curb inflation by the end of 2023, said Neena Mishra, director of ETF research at Zacks Investment Research. 

The SPDR Bloomberg 1-3 Month T-Bill ETF
BIL,
which tracks all publicly issued U.S. Treasury Bills that have a remaining maturity of less than 3 months and at least 1 month, offers a yield of 5.43%. The fund attracted over $1 billion of inflows in the week to Wednesday, the largest inflows among over 800 ETFs that MarketWatch tracked in the past week, according to FactSet data. 

Meanwhile, Mishra said investors who want active management with “better navigation to the markets” can consider the JPMorgan Ultra-Short Income ETF
JPST,
which is an actively managed fund that invests in a variety of debts including corporate issues, asset-backed securities, and mortgage-related debt as well as U.S. government and agency debt. JPST recorded $15 million of inflows in the past week and has yielded 5.76%, according to FactSet data. 

Flows into longer duration bonds, utilities sector

Despite the bond rout hitting the popular TLT fund hard as the 10-year Treasury yield surged, some retail traders have already started to buy the historic dip of the fund devoted to longer-dated Treasuries, said a team of Vanda Research data analysts led by Marco Iachini, senior vice president.

TLT attracted a total of $686 million flows in the week to Wednesday, ranking the 8th out of over 800 ETFs that MarketWatch tracked in the past week, according to FactSet data. 

Along with the strong “dip buying” in TLT, retail traders have also poured an “unprecedented amount” of capital into the utilities sector, Iachini and his team said in a Thursday note. The Utilities Select Sector SPDR Fund
XLU
recorded $141 million of inflows last week, according to FactSet data. 

“While purchases of utilities stocks are typically of a significantly smaller scale than purchases of tech stocks, the inflow seen over the past week is far larger than any other prior 5-day stretch, easily surpassing inflows into the sector at the onset of the Covid downturn,” the Vanda team said. “The flip side of this dynamic is that institutional investors have likely lightened up their utilities exposure during this bond sell-off episode, making the sector a potentially more appealing equity bet should rates be nearing a local peak.” 

See: Utilities stocks ‘decimated’ by rising rates fall into uncommon trading territory, Bespoke chart shows

Small-caps are ‘cheap for a reason,’ so don’t buy them too soon

Many small-cap stocks have traded at a significant discount to their larger-company counterparts, creating an attractive entry point for some investors who think the forward price-earnings ratio for small-caps are low enough to offer potential for outperformance in the longer run. 

However, small caps
IWM
are by nature more sensitive to higher interest rates compared with a lot of the larger-cap stocks which have the ability to be “nimble” with strong cash flow, said Urbanowicz.

“It is really important right now not to just rely on a specific sector but really have that built-in risk management at the index level to take a lot of that guesswork out of the equation,” he added.

See: Small-cap ETFs may look attractive as recession concerns fade, but blindly chasing the rally is not without risk

Defined-outcome ETFs

That’s why Urbanowicz and his team at Innovator ETFs think the increasingly popular defined-outcome ETFs, or the “buffer” funds, could limit the downside risk and help investors navigate a stormy rates environment.

See: An ETF that can’t go down? This new ‘buffer’ fund is designed to provide 100% protection against stock-market losses

For example, the Innovator Equity Defined Protection ETF
TJUL,
the “first-of-its-kind” fund, aims to offer investors the upside return of the SPDR S&P 500 ETF Trust
SPY
to a 16.62% cap, as well as a complete buffer against its downside over a two-year outcome period. 

Meanwhile, the Innovator Defined Wealth Shield ETF
BALT
offers a 20% downside buffer on the SPY every three months, which is a “very shortened outcome period” and doesn’t require the equity market to actually go up for the strategy to appreciate a value, Urbanowicz said. 

“A big reason [to consider this strategy] is it gives investors a place to not only maintain equity exposure, but also to hide out because they [funds] have known levels of risk management that are in place,” he added. 

As usual, here’s your look at the top- and bottom-performing ETFs over the past week through Wednesday, according to FactSet data.

The good…

…and the bad

New ETFs

• J.P. Morgan Asset Management Friday announced the launch of a new actively managed hedged equity ETF, JPMorgan Hedged Equity Laddered Overlay ETF
  HELO.
  The outcome-oriented ETF invests in U.S. large-cap equities with a laddered options overlay designed to provide downside hedging relative to traditional equity strategies.

• Zacks Investment Management Tuesday announced the launch of the Zacks Small and Mid Cap ETF
  SMIZ,
  which seeks to generate positive risk-adjusted returns by investing in small and mid-cap companies.

• Calamos Investments LLC Wednesday announced the launch of the Calamos Convertible Equity Alternative ETF
  CVRT,
   the first product of its kind to provide ETF investors with targeted access to equity-sensitive convertibles.

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