The Bond Market is Rising as Stocks Drop in February. But Don't Count on Long-term Bonds to Cushion Your Investment

Bonds have outperformed U.S. stocks in February as major equity benchmarks head toward a monthly decline with only a few trading days left before March. The iShares Core U.S. Aggregate Bond ETF (AGG), which tracks a broad range of investment-grade fixed-income securities in the U.S., has returned 1.8% this month through Tuesday. In contrast, the S&P 500 index has fallen 1.4% in February as investors react to signs of weakening economic data and cautious corporate earnings forecasts.

‍

While the core-bond ETF is helping to stabilize portfolios, its exposure to long-term Treasury bonds makes it vulnerable to fluctuations, especially as inflation remains above the Federal Reserve’s 2% target.

‍

According to Rick Rieder, BlackRock’s chief investment officer of global fixed income, long-term interest rates no longer serve as a reliable hedge against equity market volatility. “The concept of long-term interest rates as a hedge is archaic,” Rieder said, emphasizing that he does not view the long end of the yield curve as a protective strategy.

‍

Instead, Rieder suggests focusing on shorter-term bonds by investing in the middle of the yield curve. He manages the iShares Flexible Income Active ETF (BINC), which provides exposure to a variety of fixed-income securities and has an effective duration of about three years. This strategy takes advantage of the flat yield curve, which currently offers attractive returns at the shorter end.

‍

According to Rieder, the iShares Flexible Income Active ETF yields approximately 6.5%, and if the economy weakens, the middle of the curve is likely to perform best.

‍

The yield on the 10-year Treasury note dropped to 4.297% on Tuesday, the lowest since December 11, according to Dow Jones Market Data. This is only slightly above the 4.127% yield on the 2-year Treasury note, reflecting how closely the long and short ends of the yield curve are aligned.

‍

Investors are awaiting fresh inflation data from the personal consumption expenditures (PCE) index, the Fed’s preferred measure of inflation, which will be released on Friday, the last trading day of February.

‍

Earlier this month, a hotter-than-expected consumer price index (CPI) report on February 12 caused both stocks and bonds to fall. On that day, the iShares Core U.S. Aggregate Bond ETF lost 0.5%, while funds focusing on long-term Treasurys experienced sharper declines.

‍

The iShares 20+ Year Treasury Bond ETF (TLT) fell 1.4%, and the Vanguard Long-Term Treasury ETF (VGLT) dropped 1.3%, both exceeding the S&P 500’s 0.3% decline. Meanwhile, the iShares Flexible Income Active ETF, which focuses on shorter-duration bonds, fell only 0.1%, outperforming its peers.

‍

Rieder noted that the iShares Flexible Income Active ETF tends to experience smaller drawdowns compared to the iShares Core U.S. Aggregate Bond ETF due to its shorter-duration holdings. Data from BlackRock’s website shows that the iShares Core U.S. Aggregate Bond ETF has an effective duration of nearly six years, making it more sensitive to interest rate changes.

‍

Beyond inflation, other economic factors are influencing Treasury yields and bond prices. According to TD Securities, Treasury yields have declined since reaching their 2025 highs in mid-January due to market uncertainty surrounding trade policies, immigration, and fiscal measures. Concerns that tariffs could slow economic growth have also contributed to falling yields.

‍

Although some economic indicators and corporate earnings reports suggest softness, Rieder believes the U.S. economy remains robust but is beginning to moderate. Last week, S&P Global reported a weaker-than-expected performance in the U.S. services sector. Additionally, major corporations such as Walmart and Ford Motor Co. have issued cautious guidance despite solid quarterly performance.

‍

Rieder advises keeping an eye on mixed economic data but cautions against overreacting, as broader indicators still point to economic strength. Factors such as wage growth and significant capital expenditures by major technology firms support this outlook.

‍

According to the Bureau of Economic Analysis, the U.S. economy grew at an annual rate of 2.3% in the fourth quarter. The Federal Reserve Bank of Atlanta’s GDPNow model also estimated a 2.3% annual growth rate for the first quarter of 2025.

‍

Despite these positive signals, concerns about the growing U.S. deficit may lead investors to demand higher premiums on long-term Treasurys. Rieder believes the yield on the 10-year Treasury note could climb as high as 5%, which would pressure bond prices lower.

‍

As investors navigate uncertainties surrounding growth and inflation, Rieder emphasizes that variables remain unusually high. He also believes the Federal Reserve will keep rates steady for the foreseeable future. In contrast, the European Central Bank (ECB) may take a different approach by cutting rates consistently throughout the year, as Rieder sees Europe’s slower growth as an attractive opportunity.

‍

The iShares Flexible Income Active ETF’s portfolio extends beyond the core U.S. investment-grade market and includes exposure to agency mortgage-backed securities, high-yield corporate bonds in the U.S. and Europe, securitized assets like collateralized loan obligations, and European investment-grade corporate bonds. This diverse allocation allows the fund to capture higher yields while managing volatility.

‍

According to FactSet data, the iShares Flexible Income Active ETF has delivered a 5.8% total return in 2024, outperforming the iShares Core U.S. Aggregate Bond ETF’s 1.3% gain. The Flexible Income ETF’s focus on shorter-duration, higher-yield securities reduces its vulnerability to rising interest rates. While it holds a significant portion of high-yield corporate bonds, the fund also includes less risky assets to temper overall volatility.

‍

Rieder argues that with current interest rates offering attractive returns, investors no longer need to pursue the riskiest high-yield bonds. He believes that persistent inflation will keep the Federal Reserve from cutting rates anytime soon, suggesting that the central bank will need to see at least two months of weaker labor data before considering any policy changes.

‍