MW Bonds are rising as stocks suffer February drop. But don't count on long-term bonds as a cushion.

By Christine Idzelis

'The concept of long-term interest rates as a hedge is archaic,' says BlackRock's Rick Rieder

Bonds are up so far in February, outperforming U.S. stocks as major equities benchmarks appeared on track for a monthly loss with just a few trading days to go until March.

The iShares Core U.S. Aggregate Bond ETF AGG, an exchange-traded fund that provides broad exposure to the investment-grade fixed-income market in the U.S., has returned a total 1.8% this month through Tuesday. By contrast, the S&P 500 index SPX has dropped 1.4% so far in February, as investors have digested recent signs of softness in economic data and corporate earnings guidance.

While the popular core-bond ETF may be providing a cushion in portfolios this month, its significant exposure to long-term Treasurys means it's prone to swings in an environment where inflation remains above the Federal Reserve's 2% target. Long-duration bonds risk moving with equities on days when inflation reports surprise Wall Street in either direction, according to Rick Rieder, BlackRock's chief investment officer of global fixed income.

"The concept of long-term interest rates as a hedge is archaic," Rieder said in a phone interview. "I don't really see the long end as a hedge."

Rieder favors building a bond portfolio "using the front to the belly of the yield curve," he noted.

That means buying bonds with shorter durations. For example, Rieder actively manages the iShares Flexible Income Active ETF BINC to invest across diverse areas of the global fixed-income market, with an effective duration of around three years, according to data on BlackRock's website.

"With the yield curve this flat, you get so much yield sitting in the front to the belly," he said, adding that the iShares Flexible Income Active ETF is running a yield of around 6.5%. "If the economy softens, that's where the curve will perform the best."

Further out on the yield curve, the yield on the long-term 10-year Treasury note BX:TMUBMUSD10Y fell Tuesday to 4.297%, the lowest since Dec. 11 based on 3 p.m. Eastern time levels, according to Dow Jones Market Data. That's an only slightly higher rate than the 4.097% yield on the 2-year Treasury note BX:TMUBMUSD02Y on Tuesday.

Inflation worries

This week, investors will get a fresh reading on U.S. inflation in January from the personal-consumption expenditures index, the Fed's preferred inflation gauge. The PCE report will be released Friday, the last day of February, ahead of the U.S. stock market's opening bell.

Earlier this month, when Wall Street was surprised by a hotter-than-expected reading on U.S. inflation in January from the consumer-price index on Feb. 12, major stock benchmarks mostly fell. ETFs tracking the U.S. investment-grade bond market, which are a popular core fixed-income holding, also declined, with the iShares Core U.S. Aggregate Bond ETF losing 0.5% that day.

The stronger-than-forecast CPI inflation reading sent Treasury yields higher, hurting bond prices. Long-duration bonds were particularly volatile that day.

Funds targeting long-term Treasurys saw sharp drops on Feb. 12, with the iShares 20+ Year Treasury Bond ETF TLT slumping 1.4% and the Vanguard Long-Term Treasury ETF VGLT falling 1.3%, FactSet data show. Those losses exceeded the S&P 500's 0.3% retreat that same day.

The iShares Flexible Income Active ETF, which mainly has focused on shorter-duration securities, slipped 0.1% on Feb. 12 to outperform the iShares Core U.S. Aggregate Bond ETF.

The iShares Flexible Income Active ETF's maximum drawdowns generally have tended to be less dramatic than the index tracked by the iShares Core U.S. Aggregate Bond ETF, as it has benefited from a portfolio consisting of shorter-duration securities, according to Rieder.

While the iShares Core U.S. Aggregate Bond ETF has significant exposure to long-term Treasurys, its effective duration shakes out to almost six years, data on BlackRock's website show.

Crosscurrents

Investors are navigating crosscurrents beyond inflation that have the potential to move Treasury yields and impact the value of bond holdings.

"Treasuries have rallied significantly in recent weeks, moving from the 2025 yield highs set in mid-January to year-to-date lows," rate strategists at TD Securities said in a note emailed Tuesday. "The move has been choppy owing to significant market uncertainty on trade, immigration, and fiscal policy," they said, adding that concern that tariffs may place a drag on growth has pushed yields down.

Read: Consumer confidence sinks to 8-month low on worries about inflation and Trump tariffs

Although Treasury yields have recently declined amid "some pockets of softness" in economic data and projections in quarterly earnings reports, the U.S. economy has been operating at a "very strong" level from which it is now "moderating," according to Rieder.

On Friday, S&P Global's flash reading on the U.S. services sector was weaker than Wall Street expected. On the corporate earning front, retail giant Walmart Inc. $(WMT)$ last week provided lackluster guidance, while Ford Motor Co. $(F)$ in early February reported a quarterly sales record but delivered a softer outlook for the year.

It makes sense "to open one eye towards some data that was a bit more mixed than we anticipated," said Rieder, but added that "it's not worth overreacting" against the broader economic backdrop that has included wage growth and expectations for a large amount of capital expenditures by Big Tech companies.

Read: Zuckerberg wants to spend billions more on AI. Meta investors like that idea.

Meanwhile, real gross domestic product in the U.S. expanded at an annual rate of 2.3% in the fourth quarter, according to an estimate on Jan. 30 from the Bureau of Economic Analysis. And the Federal Reserve Bank of Atlanta's GDPNow model estimated as recently as Feb. 19 that the U.S. was expanding at a 2.3% annual rate during the first quarter of 2025.

Still, concerns over the large U.S. deficit may lead investors to demand more term premium for the closely watched 10-year Treasury note, according to Rieder.

That means the rate on the 10-year Treasury risks climbing above current levels, potentially creating losses as bond yields and prices move in opposite directions. Rieder estimated that the 10-year Treasury rate's current trading range may run to around 5% on the high end.

Markets are wrestling with a lot of uncertainty this year as investors model for growth and inflation, he said, noting that "variables are much higher than we've been used to for a long time."

Fed on hold, but ECB may 'persistently' cut

Rieder is actively managing risks related to fiscal and monetary policy, including growth and inflation worries, with a portfolio that goes beyond the core U.S. investment-grade market.

"I think Europe is growing just slow enough to be really attractive," said Rieder, adding that he expects the European Central Bank may be "cutting rates persistently this year."

The iShares Flexible Income Active ETF's diverse holdings include exposure to areas such as agency mortgage-backed securities, high-yield corporate bonds in the U.S. and Europe, securitized assets such as collateralized loan obligations and commercial mortgage-backed securities, and European investment-grade corporate bonds.

"We buy a lot of European investment-grade," said Rieder, with U.S. investors benefiting from the "currency swap."

The iShares Flexible Income Active ETF returned 5.8% on a total-return basis in 2024, according to FactSet data. The iShares Core U.S. Aggregate Bond ETF lagged, with a total 1.3% gain last year.

The iShares Flexible Income Active ETF has significant exposure to high-yield corporate bonds, which have below-investment-grade ratings and are riskier, but provide higher levels of income. Rieder said that the less risky assets held by the fund dampen the overall volatility of the portfolio, such that its maximum drawdowns have been less severe than junk bonds generally.

Meanwhile, the Fed last month paused its interest-rate cuts, leaving rates at attractive levels for fixed-income investors, he said. Investors don't have to reach for returns in the riskiest areas of the high-yield market, according to Rieder.

Sticky inflation in the U.S. "leaves you in a place where the Fed just can't do anything for a good deal of time," he said. "You need two months of softer labor data to get there."

-Christine Idzelis

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February 26, 2025 07:00 ET (12:00 GMT)

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