U.S. Treasury Bond ETFs: The Going Price of Safe?

Jonathan Bernstein, ETFzone.com Contributing Editor
March 13, 2011

U.S. treasury bonds and treasury bond ETFs are go-to safe haven assets in moments of uncertainty and crisis. But now they are more expensive than ever, and there are more of them. Are U.S. treasury bonds and U.S. treasury bond ETFs still a good place to find safety?Treasury bonds and treasury bond ETFs were among the very few assets that did not decline during the worst moments of the financial crisis in 2008-2009. Even gold and silver performed erratically during this period. U.S. treasury assets proved to be negatively correlated with the broad market. As equity benchmarks were cut in half, treasury bonds ETFs soared to new, all-time highs.By the fall of 2009, the worst of the financial crisis presumed past, high profile calls for a bear market in U.S. treasury bonds began. The reasons are self-evident. Treasuries had enjoyed a thirty-year run. The Fed funds rate cut essentially to zero could only go higher. Those early calls to exit treasuries have since become a chorus. Some of the biggest names on Wall Street are worried about treasuries- John Paulson, Jim Rogers, and recently Bill Gross, just to name a few of the most vocal.It is hard not to see the case for disinvesting in treasury bond ETFs, and for aggressive traders even selling treasuries short. The potential for higher interest rates, for inflation, the trend to a weaker dollar, the over-supply of treasuries, U.S. dependency on foreign buyers to both buy and own treasuries, possibly temporary price support from a temporary Federal Reserve buying program, massively increased U.S. government debt levels, the possibility of a ratings agency downgrade, and the historical decline of the American hegemon. Pick one. Treasury prices are vulnerable to any one of them. The assembled risk at a time when treasuries are very near their historical highs make U.S. treasuries ETFs indeed seem wildly overvalued.But for all that, when it seems that treasuries can inspire only revulsion-- trouble starts, somewhere in the world, and the story circulates that the dollar, for all its ills, is more safe than the euro or the yen or any other currency. Investors are reminded that the market for U.S. treasury assets is the world's largest and most liquid. The prices for commodities and other assets are volatile. And lo! Treasury ETFs rise again.Treasury bears continue to be disappointed. Short treasury debt was supposed to be the big trade for 2010. The opposite happened. As the sovereign debt crisis paralyzed Europe, the dollar strengthened. Demand for perceived safer U.S. debt rebounded. Treasury bonds ETFs, which had fallen from their highs in the early months of 2009, gained quickly. Then, as the debt crisis in Europe mediated and the dollar started lower again, treasuries looked vulnerable. But even this was not to be. The U.S. economic rebound, which had been firing on all cylinders, slowed, then stalled. Worried investors turned... to treasuries.The upshot: far from falling from 2009 peaks, some U.S. Treasury ETFs actually attained new highs in October 2010, surpassing even levels attained during the worst of the financial crisis. That was shortly before the Fed began QE2, its bond buying program. The chart below compares iShares Barclays 7-10 Year Treasury Bond ETF (NYSEArca:IEF - News) with the equity benchmark Standard and Poors Depositary Receipts (NYSEArca:SPY - News). The chart shows the basic inverted shape of the treasury bond fund IEF compared to the domestic equity benchmark SPY. This confirms its historically negative correlation with the domestic equity market. The chart shows IEF peaking in March 2009 as the equity ETF SPY made its nadir. But then comes the surprise. In October 2010, with equities as measured by the SPY much stronger than during 2009, the negatively correlated treasury fund IEF actually crosses its 2009 high. In October 2010, IEF traded above $100 a share for the first time ever. Since then the price of IEF has declined. But with the revolution in Tunisia spreading across the Middle East, yields are once again falling, and prices of U.S. treasury ETFs rising again.The immediate sensitivity of treasury prices to global crisis is not new but it has gained in importance in recent years. Alan Greenspan did not mention it when, speaking to congress in early 2005, he famously described persistently high long-term treasury bond prices and long term interest rate declines as a "conundrum." Greenspan reasoned that U.S. treasuries and treasury bond assets like ETFs IEF cannot be accounted for by any of the forces that classically subdue yields: low inflation, low inflation expectations, the globalization of investment.The financial crisis and Bernanke's stewardship has made plain the importance of the security dynamic not overtly a concern of the Greenspan Fed. Investment in treasuries comes not only from investors seeking safety and stability. Increasingly, governments are purchasing U.S. treasuries obligations in order to create stability. Bernanke's purchases of U.S. debt are to ensure that a wheezing U.S. economy is well-supplied with cash. China's purchases of U.S. treasury debt ensure the stability of the dollar/yuan pair. Asia's stockpiling of foreign reserves is a bulwark against the withdrawal of capital and a 1997-style collapse.But investing in stability is not the same as investing for return. Governments need to buy treasuries to secure stability should not sway the individual investor that these are good products to own from the perspective of a return on capital or even a return of capital. Calls for individual investors to put money in treasury products rings like the "Buy War Bonds" campaign for the people to lend the government money during World War II. This should be a flag to individual investors and a reminder that for good or ill the long-term interest of governments (and indeed people) in the stability of the global system is not the same as the usually shorter-term interests of investors and capital.There are three basic classes of treasury ETFs: short term, intermediate term and long term. Given the extended treasury market, at ETFZone we do not recommend that investors own intermediate term treasury ETFs such as IEF and long-dated products like iShares Barclays 20 Year Treasury Bond (NYSEArca:TLT - News). We think investors who want or need exposure to U.S. debt should seek to own the short end of the curve, funds like iShares Barclays 1-3 Year Treasury Bond (NYSEArca:SHY - News) and iShares Barclays Short Treasury (NYSEArca:SHV - News). The standard funds are listed below.

MID TERM (duration: 3-10 Yr) LONG TERM (duration: 10 Yr )

The ETFs in the third column have a higher duration than the shorter term funds. These funds are more sensitive to interest rate changes, and therefore more volatile. With volatility comes risk. As compensation for additional risk, holders of these funds can usually expect to be paid a higher yield. But current yields for longer dated treasury ETFs remain too subdued to be attractive for the risk.In addition to the term products above there are also treasury bond ETFs for investors who think that the main risk to treasuries is inflation. These funds hold bonds indexed to the consumer price index (CPI): TIP, IPE. In the last 20 years the Fed has generally fought inflation with higher interest rates which has hurt all funds including TIPS funds equally. As Greenspan noted inflation expectations and yields are unhinged. Nevertheless if inflation were accompanied by an unresponsive Fed, these two ETFs would be the ones to own.The following table shows U.S. treasury bond ETFs and their expense ratios.

BIL SPDR 1-3 Month Treasury Bill 0.14
SHV iShares Barclays Short Treasury Bond 0.15
SHY iShares Barclays 1-3 Year Treasury Bond 0.15
TUZ Pimco Short Term Bond 0.09
IEI iShares Barclays 3-7 Year Treasury Bond 0.15
ITE iShares Barclays Intermediate Term Treasury 0.14
IEF iShares Barclays 7-10 Year Treasury 0.15
PST ProShares UltraShort 7-10 Year Treasury ETF 0.95
TLH iShares Barclays 10-20 Yeat Treasury Bond 0.15
TIP iShares Barclays TIPS Bond 0.20
IPE SPDR Barclays TIPS 0.19
PLW Invesco PowerShares 1-30 Laddered Treasury Portfolio ETF 0.25
TLT iShares Barclays 20 Year Treasury Bond 0.15
TLO SPDR Barclays Long Term Treasury ETF 0.13
TBT ProShares Ultra Short 20 Treasury 0.95
EDV Vanguard Extended Duration Treasury ETF 0.14

Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds.