3 Treasury Bond ETFs to Play Rising Short Term Yields

Treasury bond ETFs have been one of the most vulnerable investment options thanks to the Fed’s decision to wrap up its QE stimulus. While we have seen long-term bond ETFs suffering the most in 2013, the picture changed in 2014 thanks to the Fed’s modified forward guidance. Unlike last year, this time short-term Treasury bond ETFs are being punished by the investors (read: Bond ETFs Experience Massive Outflows).

The Fed, which so far has vowed to keep the short-term rate near zero level, indicated in its last meeting that it could start raising interest rates six months after it fully wraps up its bond buying program this fall. Notably, the Fed's benchmark short-term rate has been at the rock-bottom level since 2008. Alongside, the Fed trimmed its bond buying program by another $10 billion to $55 billion per month.

Following this ‘six months’ statement, jitters spread across the market compelling many investors to reevaluate their bond holdings. Speculations on the exact timing of a rate hike were in full swing.

Some economists perceived the time frame of rate rise as mid 2015 while some saw it coming in the second half of 2016. Futures traders brought forward their anticipated timing of first interest rate hike to April 2015 from the previous expectation of July.

Yields Rising Faster for Short-term Treasuries

Short-term U.S. Treasury bond yields spiked the highest in almost three years after Fed Chair Janet Yellen’s comments. Notably, yields are rising on the low-and-middle end of the yield curve rather than the high-end. Yield on 2-year Treasury note jumped 25% from the level of 0.36% level seen on March 18 to 0.45% as of March 21, 2014 while in the same time frame yield on 10-year Treasury note rose 2.6% to 2.75%.

Also, the spread between 30-year bond yield and the 10-year bond yield has been narrowing. In fact, after witnessing a jump following Janet Yellen’s ‘six months’ shocker, yields on 30-year treasury bonds moved southward. Investors should note that yields on 30-year Treasuries actually fell 1 percentage point during the above-said time frame (read: 3 Bond ETFs Kick Off 2014 with Strong Inflows).

This stark contrast in rates on March 21 also came after the market digested some of the initial blow. A few days after the Fed’s comment, the market has realized that the Fed will remain data dependent and will not proceed with a pre-determined schedule. However, short-term Treasury bond ETFs still fared poorly this year. Notably, bond yields and bond prices hold an inverse relationship.

Market Impact

Thanks to this trend, short-term Treasury bond ETFs including iShares 1-3 Year Treasury Bond ETF (SHY), Schwab Short-Term U.S. Treasury ETF (SCHO), Vanguard Short-Term Government Bond ETF (VGSH) and PIMCO 1-3 Year U.S. Treasury Index Fund (TUZ) have shed their prior gains in the year-to-date time frame and delivered negative returns.

Winners in the Bond Space

As discussed, long-term bond yields actually fell in the crucial period and thus emerged as true winners this year. ETFs targeting the high-end of the yield curve gifted nice returns in 2014 and are expected to behave in the same manner as the U.S. economy nears the end of the cheap-money era. Below, we have highlighted three long-term bond ETFs in detail which could be solid picks in the current environment (read: Long-term Treasury ETFs Back in Focus).

iShares Barclays 20 Year Treasury Bond Fund (TLT)

This iShares product provides exposure to the long-term Treasury bonds by tracking the Barclays Capital U.S. 20+ Year Treasury Bond Index. It is one of the most popular and liquid ETFs in the bond space having amassed over $3.1 billion in its asset base and more than 7.5 million shares in average daily volume. Expense ratio came in at 0.15%.

Holding 23 securities in its basket, the fund focuses on the top credit rating bonds (AA+ and higher). The average maturity comes in 27.20 years and the effective duration is 16.55 years. The product gained more than 7.0% year-to-date and has a Zacks ETF Rank of 3 or ‘Hold’ rating (read: 3 Bond ETFs Surging as Interest Rates Tumble).

SPDR Barclays Capital Long Term Treasury ETF (TLO)

This fund looks to offer exposure to the Barclays Long U.S. Treasury Index. The index includes all publicly issued, U.S. Treasury securities having a remaining maturity of 10 or more years. The fund invests about $50.7 million of assets in 42 securities. It charges 13 bps in fees annually.

The average maturity comes in 24.73 years and the modified adjusted duration is 16.34 years. The product gained more than 6.50% year-to-date and has a Zacks ETF Rank of 3.

Vanguard Long-Term Government Bond ETF (VGLT)

The Fund seeks to track the performance of a market-weighted government bond index, Barclays Capital U.S. Long Government Float Adjusted Index, with a dollar-weighted average maturity of 10 to 25 years. The ETF amassed about $67.0 million in assets.

VGLT holds about 64 securities. Its average maturity is 24.3 years and its average duration comes at 16.1 years. The fund charges even less at just 12 bps in annual fees. It returned investors 6.64% so far this year and has a Zacks ETF Rank of 3.

Bottom Line

In a nutshell, treasury yield curve has been at the flattest position since 2009. Investors seem to pay more attention to the Fed’s altered ‘rate hike’ guidance. Thus, we believe that the short-term bond bonanza is less likely to return this year. Instead, ‘longer the yield curve, sweeter the return’ will be the bond investing theme in 2014.

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