Long-Term Bond ETFs: Coming Back In Style

by on August 2, 2010 | ETFs Mentioned:

Uncertainty over the prospects for the global economic recovery in recent months has prompted some investors to vacate equity positions in favor of safe havens that tend to perform well in turbulent economic environments [see Five Safe Haven ETFs]. Once upon a time, long-term bonds would have been a popular option for investors seeking safety. But this sub-asset class has fallen out of favor in the post-stimulus environment, as investors have expressed anxiety over the potentially devastating impact of eventual rate hikes.

To stimulate growth as the recession intensified, governments around the world (including the U.S.) cut interest rates to record lows. Interest rates and bond prices generally move in opposite directions, and a longer maturity generally translates into a greater sensitivity to rate changes. With rates at near-zero levels, there is nowhere to go but up, a development that could have an adverse impact on fixed income securities with maturities 20 years or more down the road.

Noting the massive capital injections made into the global financial system in recent years, investors reasoned that an uptick inflation would be inevitable. Rate hikes are a preferred tool for combating inflation rates that exceed the Fed’s “comfort zone,” so investors reasoned that Bernanke and company may be forced to engage in an aggressive rate hike campaign even if the economy failed to fully recover.

Shorting long term bonds has become more popular than ever. Consider the impressive surge in assets of the ProShares UltraShort Barclays 20+ Year Treasury (TBT), a leveraged ETF that seeks to provide daily returns equal to -200% of the change in the Barclays Capital U.S. 20+ Year Treasury Index. TBT offers investors a way to establish short exposure to long-term bonds, a play that has become quite popular. At the end of 2009, TBT had assets of about $1.5 billion. As of June 30, that figure was north of $4.5 billion. Needless to say, a lot of investors have been betting against long-term bonds, waiting for a series of interest rate hikes to hammer long-duration fixed income securities.

Hopefully those investors haven’t been holding their breath.

With the economy continuing to sputter, the consensus opinion is that a rate hike won’t occur until 2011 or perhaps even 2012. Recent CPI readings have been surprisingly tame, indicating that deflation is a more immediate concern and that the hyperinflationary environment many had feared certainly isn’t right around the corner. That takes the pressure off the Fed, allowing rates to remain low for the foreseeable future. Now some investors are taking revisiting the idea of long-term bonds, with some embracing these securities as a means of enhancing the current income portion of their portfolio’s return. Below, we profile several ETFs that offer exposure to various types of long-term bonds [for more ETF ideas, sign up for our free ETF newsletter]:

Vanguard Extended Duration Treasury ETF (EDV)

EDV follows 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. STRIPS are Treasuries whose interest and principal payments have been separated; they aren’t issued directly by the government, but rather created by investment banks and brokerages. As the name suggests, EDV’s holdings don’t mature for at least 20 years; this ETF has an average duration of about 26 years. EDV offers a relatively attractive SEC yield (north of 4%) considering the low risk of the underlying holdings; all components are AAA rated [see more breakdowns of EDV's holdings].

SPDR Barclays Long Term Treasury ETF (TLO)

State Street’s TLO measures the Barclays Capital Long U.S. Treasury Index, a benchmark that includes all publicly issued, U.S. Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value. Similar to EDV, TLO only invests entirely in AAA credit qualities. The majority of TLO’s holdings payoff coupons of between 4% and 6%–again an attractive yield for such low risk securities. From a maturity standpoint, the ETF offers exposure to maturities ranging from10-30 years [see TLO's fact sheet here].

Vanguard Long-Term Corporate Bond Index Fund (VCLT)

Vanguard’s VCLT gives investors exposure to long term corporate bonds by seeking to replicate the Barclays Capital U.S. Long Corporate Index, a benchmark that includes U.S. dollar-denominated, investment-grade, fixed-rate, taxable securities issued by industrial, utility, and financial companies, with maturities greater than 10 years. Unlike the aforementioned ETFs, VCLT steers clear of Treasuries, focusing instead on domestic and international corporate debt. So it’s no surprise that this ETF carries slightly more risk–credit qualities range from BBB to AAA–while offering a more attractive current yield. More than half of this ETF’s holdings pay coupons between 6% and 7%, with another quarter spitting off even higher coupon payments [see all of VCLT's fundamentals here].

Market Vectors Long Municipal Bond ETF (MLN)

This ETF tracks the performance of the Barclays Capital AMT-Free Long Continuous Municipal Index, a benchmark that includes investment grade municipal bonds with a nominal maturity of at least 17 years. MLN’s coupon breakdown is more modest–almost two thirds of underlying assets pay between 4% and 5%–but may be very attractive to investors who find themselves in high marginal tax brackets [see all ETFs in the Muni Bonds ETFdb Category].

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Disclosure: No positions at time of writing.