QE2 Slaughters Long-Term Treasury ETFs

by on November 3, 2010 | ETFs Mentioned:

As the U.S. economy continues to struggle despite record low interest rates and strong growth in emerging markets, Ben Bernanke and the rest of the Fed team have been forced to get more creative in their attempts to stimulate job creation and sustainable economic expansion. With interest rates already near record lows, the Fed took a widely-anticipate step on Wednesday, moving to engage in another round of quantitative easing–better known as QE2.

In this latest round of market stimulus, the Fed announced that it would be buying up close to $600 billion in Treasury bonds in an effort to send yields lower and spur greater levels of demand for borrowing and lending activities. While these tactics have had a questionable history, Bernanks and company seem optimistic that a round of bond buying will give the economy the jolt it needs to get back on track [also read Embrace QE With These Three ETFs].

Many had expected the Fed to buy up large quantities of long-term securities in an effort to reduce the cost of mortgages and other types of debt that largely impact consumers. However, the actual intent of the program is slightly different; the Fed announced that the focus of its QE would be shorter-term debt, with only 6% of its Treasury purchases coming in the form of bonds with more than 10 years until maturity. “The Fed’s action is difficult to fathom,” said Michael Cheah, a bond fund manager at SunAmerica. “It would have helped to buy longer-term securities because two ways to really affect the economy are to push mortgage rates down and longer-term borrowing rates down, and both rates are closely tied to the 10-year Treasury yield.”

So while the market was generally spot-on in terms of estimating the size of the easing program, it was way off for in its predictions of where the money would be deployed to. “People were expecting a much more spread out execution of both long- and short- term securities, instead of just short-term,” said Cheah, “So the knee-jerk reaction to the fact that the Fed is not buying as much of the 10′s and 30′s is sell.” Not surprisingly, this selling of long-term securities carried into the Government Bond ETF market, which experienced an extremely volatile day thanks to this surprise allocation by the Fed. Below we highlight some of the biggest movers in the sector thanks to this incorrect market assumption [also see Treasury ETFs: Filling In The Duration Spectrum]:

  • iShares Barclays 20 Year Treasury Bond Fund (TLT): This fund, which focuses in on Treasury securities that have a remaining maturity of at least 20 years, experienced extremely high volume during Wednesday’s session; TLT traded more than three times its normal level of volume of 7 million shares. The fund, which has an effective duration of 16.2 years, sank by 2.1% during today’s trading.
  • Vanguard Extended Duration Treasury ETF (EDV): Vanguard’s long-term bond fund offers investors exposure to the Barclays Capital U.S. Treasury STRIPS 20-30 Year Equal Par Bond Index, a benchmark that measures the investment return of Treasury STRIPS with maturities ranging from 20 to 30 years. A Treasury STRIP represents a single coupon or principal payment on a U.S. Treasury security that has been stripped into separately tradable components. This fund lost 3.8% in today’s trading thanks in large part to its high effective duration, which comes in at more than 26 years.
  • PIMCO 25+ Year Zero Coupon U.S. Treasury Index Fund (ZROZ): The single biggest loser in the Government Bond ETFdb Category was ZROZ, which sank by 4.1% on the day. This fund is another unique fixed income offering; ZROZ allocates its holdings to the final principal payments of stripped securities. Due to this approach, the fund has one of the longest average effective durations and maturities in the ETF universe at nearly 30 years. This makes the fund one of the most sensitive to any changes in interest rates or expectations, which explains why this ZROZ plummeted more than 4% on today’s Fed announcement [also read ETF Ideas For Deflation Defense].

While many long-term bond investors saw their positions lose significant value thanks to the Fed, those investors who were smart (or lucky) enough to be short long-term bonds made significant gains on the day [also read Shorting Treasuries: Four Different ETF Plays].

  • ProShares UltraShort 20+ Year Treasury Bond Fund (TBT): Much like TLT, this ProShares fund experienced extremely heavy volume more than three times its daily average. The product was also a strong performer, gaining close to 4% on the day.
  • Direxion Daily 20+ Year Treasury Bear 3x Shares (TMV): This fund, which seeks to deliver -300% of the daily returns on the NYSE 20 Year Plus Treasury Bond Index, jumped by 5.8% on the day.
  • PowerShares DB 3x Short 25+ Year Treasury Bond ETN (SBND): By far the biggest gainer on the day, SBND surged by 6.2% thanks to its triple short strategy which focuses in on T-Bonds which mature in at least 25 years from the current date.

[For more ETF analysis make sure to sign up for our free ETF newsletter or try a free seven day trial to ETFdb Pro.]

Disclosure: No positions at time of writing.