Earlier this year, with the economic recovery showing signs of sustainability and the printing presses in Washington were still red hot from an unprecedented injection of liquidity, many well-known and well-respected investors turned bearish on long term bonds. In a piece titled “Play Bear In The Bond Market” in January, Forbes columnist John Dobosz wrote that “even with current measures of inflation looking more deflationary, many investors are bracing for a bout of inflation that would send long-term bond prices lower as rates are bid higher to offset the effect of getting paid back with devalued money.” Forbes was hardly the only publication promoting short exposure to long-term bonds as a seemingly logical play on an inevitable interest rate reversal.
There’s an old Buffett mantra that calls for opportunistic investors to be greedy when others are fearful. And sure enough, anyone with the foresight to stock up on long-term bonds when everyone under the sun was predicting them to plummet has been handsomely rewarded. While financial headlines have focused on Europe’s woes and the numerous hurdles facing global equity markets, long-term bonds are quietly putting together a record year, thriving off a combination of uncertainty and yield starvation [see ETFs To Invest Like Bill Gates].
What Went Wrong
The bear case for long-term bonds was relatively straightforward, and seemingly based on a valid investment thesis. In order to stave off a depression and stimulate spending, the U.S. Fed slashed interest rates to record lows in recent years. Heading into the new year, anxiety over a surge in inflation was running high after massive injections of capital into the global financial system. It seemed reasonable to predict that CPI would begin to accelerate, forcing the Fed to raise interest rates off record lows. A rally in equity markets–the S&P 500 gained about 60% during the final ten months of 2009–gave investors hope that the recovery was off and running and that markets would be able to withstand a rate hike campaign. Because interest rate hikes make existing debt securities less attractive–investors can get a higher rate from recently issued securities–an inverse relationship often exists between interest rates and bond prices.
Long story short: “inevitable” interest rate hikes spelled disaster for long-term bonds [also read Three ETFs To Protect Against A 'Hindenburg Omen' Sighting].
Fast forward to August: many long-term bond ETFs have turned in gains of 20% on the year, including an impressive rally of nearly 10% over the last week. While uncertainty over the outlook for equity markets has certainly been responsible for part of the rush to fixed income, it clearly hasn’t been the only factor. On Monday, the PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (ZROZ) climbed 5% on a day when many major equity indexes also finished higher [see Market Turmoil Boosts Long-Term Government Bond ETFs].
So what in the name of Bill Gross is driving long term bond ETFs higher? For starters, worries about runaway inflation have largely subsided, only to be replaced by a potentially more devastating concern: deflation. Recent CPI reports have shown that prices may be headed lower–good news for consumers who see their dollar stretch further, but an unwanted development for equity markets already facing a host of other problems.
Deflationary environments can have complex ramifications on financial markets, but investors generally seek out exposure to long-term fixed income securities when CPI begins to slide. That’s because the value of a fixed stream of coupon payments increases as prices slide [see ETF Ideas For Deflation Defense].
Another driver behind the long-term bond rally is the scarcity of fixed income ETF options offering a material current return. The consensus opinion now is that the Fed won’t start hiking interest rates until the latter part of 2011, and perhaps not even until 2012. That means that yields on short-term investment grade debt will remain depressed for the foreseeable future, putting investors who rely on their portfolio to provide current returns in a tough position. The Barclays 1-3 Year Treasury Bond Fund (SHY), for example, currently has a 30-day SEC yield of 0.40%. The comparable yield for the 7-10 year fund (IEI) is just 1.46%. But jump to TLT, which has a weighted average maturity of more than 28 years, and that yield climbs to 3.75%.
Even if inflation is near zero–meaning that nominal rates equate to real return–these anemic yields don’t offer investors much to get excited about. So it’s not surprising that many are looking further down the duration curve to pick up a few additional basis points in yield [also read What's Gotten Into Treasury ETFs?].
Long Term Bond ETF Options
Whether you’re looking to pick up yield, reduce risk by moving out of equities, or deflation-proof a portfolio, long-term bonds can make an intriguing option. There are a number of ETFs offering exposure to this asset class [use the free ETF screener to find them all] including the three we have highlighted below:
- PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (ZROZ): This ETF tracks the B of A Merrill Lynch Long Treasury Principal STRIPS Index, a benchmark comprised of securities representing the final principal payments of U.S. Treasury bonds with at least 25 years remaining to maturity [see fundamentals of ZROZ here].
- iShares Barclays Capital 20+ Year Treasury Bond Fund (TLT): This ETF offers exposure to long-dated Treasuries, generally offering both a higher yield and more interest rate risk than government bonds with a shorter time to maturity [see charts of TLT here].
- Extended Duration Treasury ETF (EDV): This Vanguard fund tracks the Barclays Capital U.S. Treasury STRIPS 20-30 Year Equal Par Bond Index, a benchmark comprised of STRIPS–a single coupon or principal payment on a Treasury security that has been stripped into separately tradable components–with maturities ranging from 20 to 30 years [see technical analysis of EDV here].
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Disclosure: No positions at time of writing.