Short-Term Bond Yields Rising: Where to Go Now for Fixed Income ETFs? - ETF News And Commentary

Short-term Treasury bond ETFs, which were popular among investors last year thanks to the taper talks and rising long-term yields, now appear to be losing steam. The U.S. economy gained considerable momentum in Q2 having expended at a rate of 4%.

Though the third quarter had a shaky start, recovering housing fundamentals, benign inflation numbers, improving job data, high stimulus expectation in Europe as well as truce talks between Russia and Ukraine pushed the key U.S. benchmark – the S&P 500 – to multi-year highs. In fact in late August, the S&P 500 crossed the major milestone of 2,000 for the first time in history.

All these have led to growing concerns over the hike in short-term interest rates sooner than expected. Recent strength in economic data had led to concerns that the Fed could start raising rates in March 2015 instead of the initial June or September 2015 timelines.

This in turn has lowered the appeal for short-term bond ETFs.  As a result, yields are rising on the low-and-middle part of the yield curve rather than the long end.  Yield on 2-year Treasury note jumped 17 bps from the level of 0.39% level seen on January 2, to 0.56% on September 9. In the same time frame, yield on 10-year Treasury note fell 50 bps to 2.50% from 3%.

Short-term bond ETFs like iShares 1-3 Year Treasury Bond ETF SHY, Schwab Short-Term U.S. Treasury ETF SCHO and Vanguard Short-Term Government Bond ETF VGSH have shed about 0.14% each over the last one month.

Though August job data was on the weaker side, pushing the rate tightening speculation down, the underlying tone of the economy is positive at the current level. Whatever be the case, sooner or later, short-term interest rates are expected to move up in 2015.

Better Treasury Bets

Thanks to the flattening of the yield curve, mid and long-term U.S. Treasury counterparts could emerge true winners. The spread between 30-year bond yield and the 10-year bond yield has also been narrowing.

The European bond market is also not the right choice for yield hungry investors as the European Central Bank has cut interest rates to the record-low level by setting the key benchmark interest rate at 0.05% and is also likely to launch an asset buying program next month (read: Introductory Guide to Developed Market Bond ETF Investing).

Below, we have highlighted three long-term bond ETFs in detail which could be solid picks in the current environment. ETFs targeting the long-end of the yield curve gifted nice returns in 2014 and are expected to behave in the same manner should the Fed hike short-term rates (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 $4.5 billion in its asset base and more than 7.8 million shares in average daily volume. Expense ratio came in at 0.15%.

Holding 26 securities in its basket, the fund focuses on the top credit rating bonds (AA+ and higher). The average maturity comes in 27.08 years and the effective duration is 17.07 years. The product has gained more than 15.4% so far this year (as of September 9, 2014), more than 4% over the last three months and 0.23% in the last one month.

TLT has a Zacks ETF Rank #3 (Hold) with a High risk outlook (read: 4 Recent ETF Winners in Focus).

SPDR Barclays Capital Long Term Treasury ETF (TLO)

This fund looks to offer exposure to the Barclays Long U.S. Treasury Index. This index includes all publicly issued, U.S. Treasury securities with remaining maturity of 10 or more years. The fund invests about $80.8 million of assets in 44 securities. It charges 13 bps in fees annually. 

The average maturity comes in 24.86 years and the modified adjusted duration is 16.72 years. The product gained more than 14% in the year-to-date frame, 3.8% in the last one month and 0.03% in the last month. TLO has a Zacks ETF Rank #3 with a High risk outlook.

Vanguard Extended Duration Treasury ETF (EDV)
    
The fund tracks the Barclays Capital U.S. Treasury STRIPS 20-30 Year Equal Par Bond Index, which measures the investment return of Treasury STRIPS with maturities ranging from 20 to 30 years.

The fund is a good choice to gain high current income in the government bond space. The ETF provides the highest yield of 4.10% within the Treasury bond space. EDV manages an asset base of $245 million and holds 68 securities in its basket. The ETF is also quite sensitive to interest rate changes with an average duration of 24.8 years.

EDV is up 25.5% this year. It has also added 5.5% in the last three-month period and 1.1% in the last one month.  The fund is also a low-cost option, charging investors just 12 basis points a year. EDV has a Zacks ETF Rank #3 with a High risk outlook.

Bottom Line

Although most of the long-term bond ETFs lost last week, probably due to profit booking activity after a strong run-up so far, the underlying strength of the space remains unscathed given the rate worries in the short-term bond universe.      

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ISHARS-1-3YTB SHY: ETF Research Reports
 
SCHWAB-US ST TR SCHO: ETF Research Reports
 
VANGD-ST GOV BD VGSH: ETF Research Reports
 
ISHARS-20+YTB TLT: ETF Research Reports
 
SPDR-BC LT TRS TLO: ETF Research Reports
 
VANGD-EX DUR TR EDV: ETF Research Reports
 
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