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Are Treasury ETFs Risk-Free?

tlydon@globaltrend.com (Tom Lydon)

Exchange traded funds indexed to U.S. Treasury bonds are among the top performers in May on the risk-off trade and Europe’s debt woes.

Vanguard Extended Duration Treasury ETF (EDV - News) is up 14.7% for the month of May.

Meanwhile, yields on the 10-year note have cratered under 1.6% to all-time lows. Bond yields and prices move in opposite directions.

Although investors have scrambled into the perceived safety of Treasuries, they could face hefty losses if yields finally recover or inflation heats up.

The huge rally in Treasury ETFs this month is a sign that investors are positioning for deflation. They’re afraid of a potential credit event in Europe and signs the global economy is weakening after a solid first quarter. The pullback in stocks and oil in May also illustrate deflation fears. [Treasury ETFs Hit All-Time Highs]

The three-decade bull market in U.S. government debt has been well-documented.

However, investors rushing into Treasury ETFs could end up disappointed if yields start to revert to historical averages.

The iShares Barclays 20+ Year Treasury Bond Fund (TLT - News) has spiked the past two days on very heavy volume and could be signaling a blowoff top.

‘Greatest risk’

“The greatest risk facing fixed income investors today may not be the European periphery, but how to manage the coming rise in U.S. Treasury yields. We estimate that anyone holding a 10-year Treasury bond when yields return to their historical average stands to lose more than 30% of their money,” wrote Jan Dehn in a note from Ashmore Investment Management.

The average yield on the 10-year note over the past five decades was 6%, or closer to 7% if the spike in the early 1980s to nearly 16% is included.

Dehn thinks yields in heavily indebted developed countries like the U.S. are “vulnerable” with central banks pushing rates to all-time lows in the aftermath of the 2008 financial crisis.

Consumers are deleveraging while central banks are becoming more reluctant to support the market with additional stimulus. “There is no precedent for reversing QE of the magnitude currently in place,” Ashmore said.

Clearly, record-low bond yields in traditional safe havens such as the U.S. Germany show that investors are indeed more concerned with return of capital than return on capital.

There are several scenarios in which Treasury yields could move higher and punish bond investors. They could rise for “unhealthy” reasons such as concerns over the massive debt load in the U.S.

Or they could rise for “healthy” reasons as markets anticipate an improving economy or a resolution of the debt crisis in Europe.

The strength of Treasury ETFs this month is a victory for diversification and asset allocation because bonds have provided shelter from the sell-off in equity and commodity markets.

However, investors who have piled into Treasury ETFs should at least have an exit strategy in place.

iShares Barclays 20+ Year Treasury Bond Fund