Is the Bond Market Poised For Takeoff In The Second Half? US Aggregate Bond ETF Sees Record Inflows

The bond market in 2023 has not experienced the rally that many expected at the beginning of the year, following nightmarish performance in 2022 and rising expectations of a Fed policy turn.

Yet investor inflows into bond-related ETFs are running hot these days, fueled by bets that the fixed-income market will soon reverse this trend.

The iShares Core U.S. Aggregate Bond ETF AGG, the second-largest bond ETF in the world with $92 billion in assets under management, has seen significant inflows of $5.4 billion in the second quarter of 2023, matching its best quarter ever in the second quarter of 2020, according to Koyfin data.

Despite the strong inflow momentum, the performance of the U.S. corporate investment-grade market has been negative in 2023, down 0.4% year-to-date. The investment grade bond market still remains 15% lower than its level at the beginning of 2022 and 18.6% below its record highs of 2020.

No US Recession, Hawkish Fed Prevent Bond Rally in 2023

The bond market’s failure to rally in 2023 can be attributed to a stronger-than-expected U.S. economy and job market, both of which have materially reduced risks of a recession. This has led the Federal Reserve to keep focusing on combating inflation through further interest rate hikes, which hurt fixed-income assets.

Bond bulls who expected a Fed reversal and priced in rate cuts this year have seen their optimistic expectations significantly reduced by the resiliency of the U.S. economy.

Compared to the lows of October 2022, the U.S. bond market ETF has only gained 4.5%, while the S&P 500 Index, tracked by the SPDR S&P 500 ETF Trust SPY, has gained 27.6%. This stark performance difference highlights the clear overperformance of stocks compared to bonds in the first half of 2023.

Chart: US IG Bonds Have Barely Recovered From 2022 Rout

As Yields Rise, Bond Bulls Become Even More Bullish

Despite the lackluster performance of the bond market in 2023, some of the largest bond managers, such as Brandywine Global Investment Management, Columbia Threadneedle Investments and Vanguard Group Inc., maintain a bullish view on the U.S. debt market.

These managers are confident that a strong fixed-income rally is on the horizon. They are hesitant to give up now that ultra-safe Treasury bills yielding around 5% represent an appealing opportunity today.

Roger Hallam, global head of rates at Vanguard Asset Management, recently said “the bonds-are-back narrative still holds,” adding that fixed-income assets offer “attractive coupons and ballast to a portfolio, and as you saw in March, if things go badly, bonds can rally a lot."

“For 2024, I put my chips on the market that the lagged effects of tightening means the Fed will cut," said Gene Tannuzzo, global head of fixed income at Columbia Threadneedle Investments.

Yields on U.S. investment-grade corporate bonds are averaging around 5.6%, a significant increase from 2.3% at the start of 2022 and the low of 1.8% in 2021.