As U.S. Treasury Secretary Janet Yellen predicts that the U.S. government will run out of money within just five days, negotiators are scrambling to avert a historic and potentially catastrophic U.S. default. The outcome of debt ceiling talks will have a significant impact on both the stock and bond markets, with Treasury yields likely to experience volatility at the slightest news. Analysts predict that the U.S. Treasury may reach its minimal cash level on June 6 or run out of funds altogether by June 9 if the debt ceiling is not raised. In this article, we highlight how five bond ETFs may react to the debt limit announcements in the coming hours.
1) iShares 0-3 Month Treasury Bond ETF SGOV
Managed by Blackrock Inc. BLK, this ETF invests in Treasury bills with maturities up to three months and is particularly sensitive to the June deadline. This ETF’s short-term T-bill rates will fall if the debt ceiling is lifted, increasing its value.
2) iShares 1-3 Year Treasury Bond ETF SHY
This ETF is particularly sensitive to market Fed rate expectations that are reflected in two-year Treasury yield fluctuations. A compromise would keep the Fed focused on recent data on inflation and labor markets, supporting market predictions for a June rate hike. If short-term rates rise, the value of this ETF will decrease, but yield-seeking investors may be able to enter at an attractive point if they believe the Fed will soon end its tightening cycle. In a no-deal scenario where the U.S. defaults, the Fed would likely opt to stop raising interest rates, leading to a rise in the ETF’s value.
3) iShares 20+ Year Treasury Bond ETF TLT
This ETF is sensitive to long-term Treasury yield changes that are heavily influenced by growth and inflation forecasts. A deal is likely to increase duration-exposed Treasury yields, with the extent depending on the amount of expenditure reductions. Lower-than-expected budget cutbacks will provide a stronger push to yields than a debt limit agreement indicating substantial expenditure cuts.
4) iShares iBoxx $ High Yield Corporate Bond ETF HYG
This ETF invests in high-yield corporate bonds denominated in U.S. dollars, which is a high-risk asset closely tied to market sentiment. The ETF’s value is expected to rise if the debt limit resolution is viewed positively by the market and the broader risk-on mood. But an agreement with significant budget cutbacks or a no-deal scenario could cause investors to flee to safer alternatives, resulting in weakness in high-yield corporates.
5) iShares J.P. Morgan USD Emerging Market Bond ETF EMB
This ETF invests in developing market, dollar-denominated fixed-income instruments and may experience significant volatility depending on whether or not an agreement on the debt limit is reached. Given that developing market bonds are a risky asset class, this ETF is likely to experience the same impact as HYG. A broad risk-off sentiment could spark losses in EM bonds, while this market is likely to benefit from an increasing risk appetite.
Chart: Performance of SHY, TLT, EMB and HYG Year-To-Date