The top 20 bond ETFs of 2023

January 26, 2024 3:10 PM

With the investing world eagerly anticipating cuts in interest rates by the Fed this year, bond funds bounced back toward the end of 2023 from steep declines over the previous 21 months.

The Central Bank's indication in December that it's likely to slash rates three times in the second half of 2024 added to the momentum in the fourth quarter around bond funds in a position to get high yields and bumps in prices at the same time. That scenario will disrupt the traditional inverse relationship between bond yields tied to the interest rates and the asset's prices.

Bond funds had been "on pace for a third-consecutive year of losses" in 2023 before "a fourth-quarter comeback" in the asset class "rewarded those who stayed the course," according to a report by Morningstar Research Analyst Thomas Murphy. The macroeconomic conditions particularly favored products in the high-yield, longer-duration and emerging-markets categories of fixed income funds, Murphy wrote.

The top 20 bond ETFs of 2023 — ranked below using data from Morningstar Direct — include those types of products, as well as a preferred stock fund linked to equity that's often grouped with bonds due to the fixed dividends paid to the shareholders.

Financial advisors know that the Fed's stated goal of 2% inflation "may not happen this year," so they're asking themselves "what did you do for clients" before the cuts, according to certified financial planner Raman Singh, the founder of Phoenix-based Singh Private Wealth Management. With interest rates remaining high for the time being, the "bond ETFs will shoot up," he noted. Clients may find a better hedge against stock and rate volatility — as well as tax advantages — through bonds themselves rather than baskets of them.

"I know I can lock in that rate. I own the individual bond, and I don't have to worry about the interest rate changing," Singh said, noting the contrasts with the hundreds of individual bonds collected together in an ETF. "You cannot really get a sustainable rate of return. It changes with the outlook of what the interest rates are going to do."

As the traditional companion to stocks in a diversified investment portfolio, bonds are looking even more appealing in 2024 to individual advisors and Wall Street's largest firms.

"The probability of a recession has eased considerably as economic growth remains more resilient than expected," Larry Adam, the chief investment officer for the Raymond James Private Client Group, wrote in a report last week. "And, while consensus now expects a soft, non-recessionary landing in 2024, our economist still has the 'mildest ever' recession penciled in this year. Why? We expect higher borrowing costs, rising credit card debt and a weaker job market to dampen, but not derail consumer spending.

"This should drive the economy's growth rate from a 2.3% pace in 2023 to a below-trend rate of [about] 1% in 2024. It should also drive inflation lower, building a case for less restrictive Fed policy in the coming months," he added. "A continuation of this favorable macro backdrop of moderating growth (slowing, but still at a level to avoid a deep recession) and cooling inflation should provide support for the bond market and lead to lower yields in the months ahead."

And those lower yields for newer fixed-income products will boost the value of the longer-duration bonds.

In addition to the fact that interest payments on municipal bonds may be "triple tax-exempt" in areas like New York or California that have three levels of income taxes, individual bond ladders composed of debt that have different maturity dates can offer loss-harvesting opportunities for longer periods than some direct-indexing stock strategies, according to a blog this month by Jonathan Rocafort and Issac Kuo of asset management firm Parametric.

To see Morningstar Direct's rankings of the top-performing bond ETFs of last year, scroll down the slideshow. And follow the links below to see more investment analysis from Financial Planning: