I recently got an email from a subscriber this past week regarding a topic that I think is going to become more important in the coming months.

Bond ETFs haven’t gotten a whole lot of attention lately. Most investors in 2024 have targeted tech & the magnificent 7. Based on returns, the interest is justifiable, but bonds in many cases have gotten unfairly written off following the 2022 bond bear market.

Bonds haven’t necessarily been surging this year, but they’ve put up about the returns you might expect given current yield levels.

Junk bonds, somewhat surprisingly (to me at least), continue to lead the pack with gains of nearly 6%. T-bills have returned a little over 3%, as have total bond market ETFs. Long-term Treasuries have clawed all the way back from double digit losses earlier this year to post a small gain so far in 2024.

But that’s the past 8 months. Where are bonds headed from here?

State of the Fixed Income Market

We know that the Fed is going to cut rates in September. The only question now is whether they’ll cut by a quarter-point or a half-point (the futures market is betting its going to be a quarter-point). Regardless of what happens at the next meeting, the markets are expecting a total of 75-100 basis points of cuts this year before the Fed Funds rate dips all the way to 3% by the end of 2025.

That presents opportunities for fixed income investors.

If yields are going to drop over the next several quarters, it’s likely because the economy is trending towards recession and/or there’s a flight to safety trade happening. If that’s the case, Treasuries are looking at producing solid gains with the iShares 20+ Year Treasury Bond ETF (TLT) in line for roughly a 34% gain if rates drop by 200 basis points.

Short-term, ultra-high grade corporate bonds may hold up OK, but all other forms of corporate debt are likely to struggle. In that event, spreads would likely expand considerably and offset any potential gains from yields shrinking. Long-term investment-grade corporates would likely lose, but junk bonds are facing the deepest losses.

That’s because credit spreads currently are far below where they should be based on current risks.

Historically, a high yield spread of 6% is where things start falling apart. As you can see, we’re nowhere near that level now, but conditions can also change very quickly. I see 6% is the trigger point because once spreads hit that level, they usually don’t stop until they get to 8% or higher. The only exception was in June 2022. High yield spreads touched 5.92% before getting turned back and eventually retreating to current levels.

Even if they don’t get to 6%, there’s a lot of damage that can still be done if this number moves to even 4-5%. That alone would trigger losses of 5-10% or more in corporate credit, depending on the quality profile.

The upside play, in my opinion, is in Treasuries. If you want to go for the home run swing, TLT is probably the best option. If you want a more diversified play on Treasuries, the iShares U.S. Treasury Bond ETF (GOVT) will also work. Corporates would start to look dangerous if we go down the economic slowdown route.

In terms of ETF net flows, investors have been moving into fixed income this year. They’ve taken in about half of the net new money that equities have on an absolute basis, but have taken in twice as much on a relative basis.

The biggest inflows are coming from the long-term and intermediate-term Treasury ETFs, so there is some evidence that fixed income investors are positioning themselves a little more defensively here.

However, retirement investing is more about broad diversification than market timing. Tilting a bond portfolio in one direction or another based on your belief about where markets and the economy are headed makes some sense, but full-scale shifts into and/or out of an asset class would be ill-advised. Market timing usually doesn’t work and it can negatively impact long-term strategies.

Let’s take a look at some bond ETFs that would fit nicely as part of a core retirement portfolio foundation. I’ve identified 21 of them split across four broader categories.

Core Bond ETFs

These are sort of the all-in-one fixed income solutions. They cover multiple corners of the bond market, but they’re not always a complete portfolio. This is a category where you need to dig in a little to discover the differences.

• Vanguard Total Bond Market ETF (BND)

• iShares Core Total USD Bond Market ETF (IUSB)

• SPDR Portfolio Aggregate Bond ETF (SPAB)

• Schwab U.S. Aggregate Bond ETF (SCHZ)

• iShares Core U.S. Aggregate Bond ETF (AGG)

• Fidelity Total Bond ETF (FBND)

BND, AGG, SPAB and SCHZ are substantially similar. The problem with these funds is that they have 2/3 of their portfolio invested in government securities. That’s a lot to commit to one segment and these funds lack ideal diversity. IUSB has a somewhat smaller allocation to government securities and adds a small exposure to junk bonds, which the other four ETFs don’t. FBND goes a little further by investing 11% of the fund’s assets into junk.

High Yield Bond ETFs

These have been very popular since 2022, mainly because investors are discounting current downside risks. That creates a poor risk/reward profile in the near-term, but it does make some sense to dedicate at least a little bit of a retirement portfolio to this group.

• iShares Broad USD High Yield Corporate Bond ETF (USHY)

• iShares iBoxx $ High Yield Corporate Bond ETF (HYG)

• SPDR Bloomberg High Yield Bond ETF (JNK)

• SPDR Portfolio High Yield Bond ETF (SPHY)

• iShares 0-5 Year High Yield Corporate Bond ETF (SHYG)

Here, broader is better. USHY, HYG, JNK and SPHY do a good job of covering the spectrum. SHYG may be a better option, though, because it cuts duration risk by about 30% and actually offers a higher yield than HYG thanks to the inverted yield curve.

Target Duration Bond ETFs

These are a relatively new asset class, but they’re a great way to laser focus your bond exposures. The two primary issuers of these products - BondBloxx and the U.S. benchmark series from F/M Investments & Genoa Asset Management. What’s even better from an investor perspective is that these issuers are offering these products for razor-thin expense ratios. The U.S. Treasury series focuses strictly on government bonds. BondBloxx offers funds targeting durations, credit qualities and sectors.

• U.S. Treasury 3 Month Bill ETF (TBIL)

• BondBloxx Bloomberg One Year Target Duration U.S. Treasury ETF (XONE)

• BondBloxx Bloomberg Five Year Target Duration U.S. Treasury ETF (XFIV)

• BondBloxx Bloomberg Ten Year Target Duration U.S. Treasury ETF (XTEN)

• U.S. Treasury 30 Year Bond ETF (UTHY)

BondBloxx offers the cheaper products, but there are other considerations at play. I chose TBIL for ultra-short Treasuries because it’s a much larger and more liquid ETF. XONE, XFIV and XTEN are cheaper than the alternatives. BondBoxx doesn’t offer a 30-year bond ETF.

Ultra Short Bond ETFs

These are especially attractive here because they offer the big yields without the share price volatility. You can certainly stick with T-bills for this and call it a day, but there are plenty of other more diversified choices worth considering.

• PIMCO Enhanced Short Maturity Active ETF (MINT)

• BlackRock Short Duration Bond ETF (NEAR)

• Vanguard Ultra-Short Bond ETF (VUSB)

• JPMorgan Ultra-Short Income ETF (JPST)

• PGIM Ultra-Short Bond ETF (PULS)

NEAR is the only one of these funds with meaningful Treasury exposure (currently 38% of assets). The rest are mostly corporates and asset-backed securities. NEAR also has a slightly higher duration. These funds also offer yields in the 5% range, but their diversity and, in some cases, active management make them a nice alternative income source.

How These Fit Into A Retirement Plan

If you’re purely a yield seeker or living off of your portfolio for income, I think it makes sense to focus on the shorter end of the curve. 5% yields are still readily available with there’s virtually no share price risk with T-bills. Even the funds listed in the ultra-short category above fluctuate very little. You could add duration if you want to take a chance on which way the bond market might move next, but taking the yield and calling it a day seems like a wiser move.

The core bond ETFs make sense in almost every portfolio. Personally, I prefer IUSB because it’s a bit more diversified and you can get it for next to nothing in cost. All of them are tilted a little heavier towards Treasuries than I’d probably prefer, but they still make for a good core fixed income position.

The other two groups are useful for tilting your portfolio in a particular direction. The target duration ETFs are especially interesting to me. Most bond ETFs target a range of maturities, but I like that you can really achieve precision with these products.

Final Thoughts

We hear a lot about how the 60/40 portfolio is dead, but I disagree. It was certainly less than ideal when the Fed had rates at zero and it was certainly less than ideal when Treasuries were down 20% in 2022. If you fast forward to today, however, bonds are in a much more balanced starting spot.

A risk-free 5% yield fits nicely into either the bond or cash position in a portfolio and there’s share price upside now available if rates start to decline. Don’t give up on bonds just yet! They may become important very soon!