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Medium Term Treasury Bond ETF Investing 101

As far as ETFs are concerned, 2013 has been pretty much a year for the short term segment so far. Besides the huge surge in interest for Japan ETFs, short term bond ETFs were among the hottest picks for investors (read DXJ vs. DBJP: Which is the Better Hedged Japan ETF?).

The space saw great inflows in their asset bases with funds like Vanguard Short Term Bond ETF (BSV), iShares Barclays 1-3 Year Credit Bond ETF (CSJ) and iShares Barclays Short Treasury Bond ETF (SHV) topping the creation list in the short term bond ETF space (see Are Short Term Bond ETFs the New Safe Haven?).

Nevertheless, the recent surge in the asset inflow of medium term U.S Treasury bond ETFs point towards the fact that the safety of U.S treasuries has not entirely been discarded by investors, even amidst the overall optimism in the equity markets.

Investment case for the Intermediate Term Treasury Bond ETFs

These ETFs predominantly target the intermediate part of the treasury yield curve and carry moderate levels of interest rate risk. In fact, these can be considered to be the sweet spots across the yield curve which do not limit the income opportunity as opposed to short term bond funds. At the same time, the medium term bonds limit the interest rate risks as opposed to longer dated Treasury bond ETFs.

In fact, considering the present circumstances, the intermediate term Treasury bond ETFs may have the most lucrative investment opportunity compared to the long and short dated counterparts.

The short term interest rates are almost nearing zero percent in yields resulting in negative real returns. At the same time, concerns are rising over a possible interest rate increase for the longer dated Treasury bonds, which would cause big losses in these products (see Time to Buy Floating Rate ETFs?).

If one takes the above scenarios together, investors primarily need two things from their bond ETFs— a decent payout of income coupled with relative insulation from rising interest rates. And nothing fits the bill like the intermediate term Treasury bond ETFs.

ETF Choices to Target Intermediate Treasury Bonds

Probably two of the most popular and widely traded funds from the medium term bond ETF space are the iShares Barclays 3-7 Year Treasury Bond ETF (IEI) and the iShares Barclays 7-10 Year Treasury Bond ETF (IEF). The former has an asset base of around $3.8 billion while the latter has managed to amass $4.7 billion in total assets.

Both these iShares ETFs charge investors 15 basis points in fees and expenses and have high average daily volumes. However, IEF tracks the performance of Treasury bonds which are further away in terms of residual maturity compared to IEI.

This fact is highlighted by the average maturity of the two ETFs, with IEI having a weighted average maturity of 4.62 years compared to IEF’s 8.36 years.

Also, IEF lies higher in the hierarchy of risk return tradeoff as its average duration of 7.53 years is one of the highest in the intermediate term Treasury Bond ETF space. In comparison, IEI has an average duration of 4.41 years suggesting it has a much lower level of duration risk (see Time to Buy The Hedged European ETF?).

Launched in May of 2007, the SPDR Barclays Intermediate Term Treasury ETF (ITE) is another choice from the intermediate term Treasury bond ETF space. It has a fairly large window of maturity from which it can pick treasury bonds for its portfolio. It targets Treasuries having a residual maturity between 1 and 10 years.

It has an asset base of $169.69 million and trades in fairly large quantities. Not surprisingly, it sports a paltry dividend yield of 1.53%.

It holds around 194 securities in its portfolio and has an average maturity of 3.88 years. The ETF also has moderate levels of interest rate risk as measured by its average duration of 3.68 years.

The Vanguard Intermediate Term Government Bond ETF (VGIT) is another option available to the investors to gain exposure in the medium term treasury bond ETF space. Still investors should note that it does not have a large asset base and more shares are traded in most of the fund’s counterparts.

Nevertheless, it targets bonds having a residual maturity between 5 to 10 years; however, most of the bonds in its portfolio are comprised of the shorter end of this maturity spectrum.

This fact is highlighted by the fact that it has a weighted average of 5.4 years to maturity and a moderate level of interest rate sensitivity as measured by an average duration of 5.1 years (read ECB Rate Cut: How Did It Impact Euro ETFs?).

VGIT has an asset base of approximately $186.13 million and charges investors 12 basis points in fees and expenses.

For investors who are willing to welcome some extra risk in their portfolio the ProShares Ultra 7-10 Year Treasury Bond ETF (UST) might come in handy. The ETF has been an extremely popular choice among investors lately as the fund has seen abnormally high inflows in its asset base lately.

The ETF is a 2X leveraged version of IEF and tracks twice the daily performance of the Barclays Capital U.S. 7-10 Year Treasury Index. Since it involves leverage and daily rebalancing, the ETF charges a hefty premium in the form of expense ratio which stands at 95 basis points.

However, investors should note that the ETF might not prove to be a good candidate for a buy and hold strategy since the rebalancing is done on a daily basis. Therefore, the actual results may vary from the targeted 200% of the Index returns if held for more than one day.

However, with the backdrop of falling interest rates and an ultra loose interest rate policy by the Federal Reserve, the leveraged ETF, UST, has completely crushed its non leveraged counterparts in terms of cumulative performance.

The following chart depicts the performance of all the non leveraged ETFs discussed in the article from the medium term ETF space. The time horizon in consideration is 3 years.

Bottom Line

As we can see, all of the funds have performed in a relatively tight range over the past few years. The biggest winner has easily been IEF though, as this product has crushed its competitors.

A large part of this outperformance is due to IEF’s position on the yield curve when compared to other treasury bond ETFs in the medium segment of the curve. And in a scenario of falling interest rates, the returns for this are bound to be higher for these higher duration securities rather than those that have comparatively shorter durations (see Cambria Launches Shareholder Yield ETF (SYLD)).

Nevertheless, it is important to consider that all Treasury ETFs have had an extremely impressive run thus far, therefore the possibility of a top in these ETFs cannot be ruled out.

This is especially true considering a possible QE exit by the Fed and interest rates creeping upwards, especially for the longer dated bonds. Investors should therefore exercise caution before investing in these products, especially higher duration ones.

Until that time though, products in the middle portion of the curve, such as those highlighted above, could present themselves as solid options for investors seeking to make a low risk investment that still has a bit of yield in today’s market environment.

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