Bond ETF Investors Choose Quality Over Yield

At the beginning of 2014, the yield on the 10-Year Treasury Note hovered near 3 percent as fixed-income investors worried that global growth would spur higher interest rates. Since that time, Treasury yields have fallen under 2.4 percent and spurred a flight to quality in investment grade debt.

The iShares iBoxx $ Investment Grade Corporate Bond ETF LQD invests in over 1,200 fixed-coupon securities of investment-grade corporations. LQD pays a 30-day SEC yield of 3.16 percent and charges an expense ratio of just 0.15 percent.

This ETF has thrived this year as investors have come flooding out of the high-yield market and sought the shelter of higher rated corporate debt. LQD has posted a total year-to-date return of 4.5 percent and is trading near its 2014 highs.

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This strong performance has also led to more than $1.2 billion in new inflows this year, which has boosted total assets in LQD to $17.5 billion.

Conversely, the iShares iBoxx $ High Yield Corporate Bond ETF HYG and SPDR Barclays High Yield Bond ETF JNK have been in a state of decline since the mid-point of 2014 that has derailed appetite for riskier securities. The majority of assets in HYG and JNK are allocated to B and C-rated corporate bonds that are more sensitive to economic and risk cycles rather than interest rate fluctuations.

This underperformance has led to a wave of outflows from these lower credit-rated ETFs. HYG has lost more than $1.6 billion in assets, while JNK has seen $650 million leave since the beginning of the year.

These dollars have been reallocated to investment-grade, treasury, mortgage, or aggregate bond funds which are continuing to see strong demand amid safe haven buying.

The real game changer in fixed-income markets will be the Federal Reserve’s exit from quantitative easing measures and subsequent initial rate hike next year. This could roil bonds and lead to additional repositioning for a new credit and interest rate tightening cycle that hasn't been experienced in years.

The Fed is set to release its latest monthly meeting minutes on Wednesday, which may provide additional indicators of policy changes on the horizon.