Fixed-income investing has been viewed with extreme skepticism over the past few quarters. While there are a number of reasons for this, the big one is the current rock-bottom interest rates in the U.S.
The ultra-low interest rates had caused many investors to search for yields in riskier investment avenues such as preferred stocks, high-yield bonds, real-estate investment trusts, and master limited partnerships.
Nevertheless, Treasury bonds have always been the backbone of fixed-income investing. These bonds are comfortably at the zenith as far as creditworthiness is concerned, providing investors comfortable margins of safety in terms of default risk. This is primarily because their principal and interest repayments are backed by the U.S.government itself, which has an extremely high credit rating.
Of course, by no means does this make these financial instruments absolutely risk-free. The recent rise in interest rates has made for a bearish mood among these highly rated bonds. Because interest rates and bond prices have an inverse relationship, any rise in interest rates will cause bonds to lose value, which is exactly what has happened.
While the benchmark 10-year rates have increased from about 1.6% to a high of 2.8%, the Treasury bonds have witnessed pretty rough trading sessions in the recent past. The chart below, which shows the recent performance of three exchange-traded funds that track longer-dated Treasury notes. Treasuries with longer maturity periods have are more sensitive to changing interest rates than more short-term notes. The three ETFs in question are the iShares Barclays 20+ Year Treasury Bond ETF (NYSEMKT: TLT ) , the iShares Barclays 10-20 Year Treasury Bond ETF (NYSEMKT: TLH ) , and the Vanguard Long-Term Bond ETF (NYSEMKT: BLV ) .
As you can see, these Treasury bond ETFs have had a pretty rough time over the past quarter. It is worth noticing here that the benchmark interest rates on Treasury bonds had started to inch upward around May thanks to the anxiety surrounding the fate of the Federal Reserve's bond-buying program and talks of "tapering." That's exactly when investors turned bearish on these ETFs.
Let's take a closer look at these downtrodden funds.
The iShares Barclays 20+ Year Treasury Bond ETF was launched in July of 2002, and since then it has amassed an asset base of about $3 billion. It charges investors an expense ratio of 15 basis points and pays out 2.95% in yields .
The ETF tracks the performance of longer-dated Treasury bonds that have a residual maturity of 20 years or more. It is also worth mentioning that it has an extremely high interest-rate risk as measured by its average duration of 16.27.
Launched in April of 2007, the Vanguard Long-Term Bond ETF tracks the performance of not only longer-dated Treasury bonds but also corporate bonds. It has an asset base of approximately $630 million and charges investors an expense ratio of 0.10%.
This ETF also has a high interest-rate risk, made evident evident by its average duration of 14.1. About 38% of its portfolio is comprised of Treasury notes with an average maturity of more than 20 years. However, it has a yield of about 4.5%, which is higher than its counterparts. This is primarily due to its broad focus on corporate bonds, which are typically higher-yielding than Treasury bonds.
Probably the least risky of the three is the iShares Barclays 10-20 Year Treasury Bond ETF, as it has an average duration of 9.62. This owes primarily to the fact that the ETF tracks Treasury bonds with a remaining maturity of 10-20 years, whereas the other two ETFs track the performance of bonds with 20-plus years of remaining maturity.
Also highlighting its lower risk is the fact that the ETF has slumped less that its counterparts over the course of the last six months. It manages an asset base of about $295 million and has an expense ratio of 15 basis points.
The Federal Reserve will inevitably start to scale back its bond-buying program at some point. This will cause interest rates to rise further and ultimately reach pre-recession levels. But the big question remains when. Until then, uncertainty will be the name of the game.
Thus these longer-dated Treasury Bond ETFs are surely in for some more pain ahead, so they should be avoided, at least for the time being.