Despite a downgrade of U.S. Treasury debt in the summer of 2011,
bond ETFs have remained extremely popular among investors. Many
continued to flow into these securities as havens of safety as
emerging markets and Europe appeared on the brink of a broad
calamity to end the year.
Yet, as we have gone further into 2012, some of these fears seem
unwarranted as the U.S. economy appears to be on the mend, emerging
markets are seemingly winning the battle against inflation, and
European woes continue to subside. As a result, equity investing
has once again become popular, pushing major benchmarks back
towards multiyear highs in the process.
This trend, which is finally trickling down to retail investors,
has made fixed income extremely unpopular in recent weeks, pushing
many investors out of these securities in the process. Given that
rates on bonds are expected to remain low for quite some time, the
push to equities could continue this year leaving those who are
committed to the lower volatility fixed income world in a difficult
spot for their allocations this year (read Three Bond ETFs For A
Fixed Income Bear Market).
This is especially true for those who are in the long term bond
ETF space. This corner of the market has been one of the better
performers over the past 52 weeks but has been on a serious slump
so far in 2012.
Investors had sought this sector late in 2011 when it appeared
that we were in for a long malaise as it offered stability during
deflation scares. However, now that commodity prices are rising and
stocks are also surging, this idea is beginning to fall by the
wayside, causing many investors to fly out of long term debt in the
process.
This is best manifested in the case of the two ultra long term
bond ETFs on the market today, the PIMCO 25+ Year Zero
Coupon US Treasury Index Fund (ZROZ) and the
Vanguard Extended Duration Treasury Index Fund
(EDV). These two products each put up gains of over 40% in
the trailing 52 week period but now they are both down double
digits in year-to-date terms (read Forget About Low Rates With
These Bond ETFs).
In fact, these are the only two bond ETFs—in the unleveraged
non-inverse space—that have seen losses exceed 10% on the year.
Meanwhile, their gains from the one year time period are still
crushing all others in the space by a wide margin; nearly 1,000
basis points separate the two from the next best performing fund in
the space.
This should demonstrate just how sharp the reversal has been in
the space over the last few months, and how interest rate
sensitivity can dramatically impact bond fund returns. Both the
products have average durations over 25 years, ensuring that they
are usually the biggest winners when rates are falling, but are
also among the biggest losers when interest rates are on the
rise.
Given this sharp reversal, and the continued move towards
marginally higher rates in the short-term, it may be time for
investors to consider cycling into other types of securities before
any more losses are accumulated. This could be a great idea for
those who are worried about more bond losses piling up, or for
investors who are dismayed over recent equity performance and would
like to position themselves for a reversal in stocks. For these
investors, any of the following products could make for interesting
choices during this uncertain bond environment:
iPath US Treasury Steepener ETN (STPP)
This note looks to give investors the ability to capture returns
from a ‘steepening’ of the U.S. Treasury curve via investments in
two year and 10 year T-bills. This technique looks to gain when
longer dated bills are seeing rates rise, especially when compared
to short term notes (Looking For Safety? Try These Money Market
ETFs).
This has been the trend as of late, as short term securities
have moved up slightly while longer-term bonds have seen marked
increases in their rates. Thanks to this recent move, STPP has been
a solid performer and could continue to be if investors demand more
from longer term debt holdings.
Thanks to this, STPP has added about 5.8% in the past one month
period, including a 5% jump in the past week alone. With this
performance, the fund has now added about 4.1% so far this year,
making it an interesting compliment to bond heavy portfolios should
rates continue to rise in longer dated securities.
PowerShares DB US Inflation ETN (INFL)
Generally speaking, when expectations of inflation are on the
rise over the long haul, long dated securities can see their rates
go up. This is because investors feel the need to be compensated
for the higher risk of inflation with bigger payouts, especially
when the Fed seems unlikely to hike rates any time soon.
In order to play this trend, investors could consider INFL for a
new way to achieve exposure. The note tracks the DBIQ
Duration-Adjusted Inflation Index which looks to capture changes in
inflation expectations. This is done by tacking a long position in
TIPS while undertaking a simultaneous short position in traditional
Treasury bonds (read Ten Best New ETFs Of 2011).
In this strategy, future implied inflation trends are seen by an
increase in inflows to TIPS while investors move out of unprotected
Treasury bonds at the same time. Given the weak performance of
Treasury bonds and the average performance of TIPS this year, INFL
has been a solid performer adding about 6.8% in the short-term
period.
Additional ETF Options
Beyond the choices outlined above, investors could also consider
floating rate bonds or short-term debt. These securities generally
have low durations and thus are not very sensitive to interest rate
changes. However, it should be noted that these products usually
have paltry yields when compared to their long-term counterparts in
the space (read Do You Need A Floating Rate Bond ETF?).
As a result, these short duration ETFs are probably
inappropriate for those looking for income at this time. This is
not unlike INFL or STPP either though as these products do not
generally pay out anything to investors and often have higher costs
as well.
However, so far in 2012, the ETNs outlined above have been the
top performers in the space, suggesting that if you are going to
sacrifice yield for safety, you might as well look at either of the
notes above for a quality, but often over looked, way to protect
against a potential bear market in bond ETFs. This strategy could
pay off, especially when compared to floating rate or short-term
debt should current trends continue.
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