ZROZ PIMCO 25 Plus Yr Zero Coupon US Treasury Index ETF

Despite a downgrade of U.S. Treasury debt in the summer of 2011, bond ETFs have remained extremely popular among investors. Many continued to flow into these securities as havens of safety as emerging markets and Europe appeared on the brink of a broad calamity to end the year.

Yet, as we have gone further into 2012, some of these fears seem unwarranted as the U.S. economy appears to be on the mend, emerging markets are seemingly winning the battle against inflation, and European woes continue to subside. As a result, equity investing has once again become popular, pushing major benchmarks back towards multiyear highs in the process.

This trend, which is finally trickling down to retail investors, has made fixed income extremely unpopular in recent weeks, pushing many investors out of these securities in the process. Given that rates on bonds are expected to remain low for quite some time, the push to equities could continue this year leaving those who are committed to the lower volatility fixed income world in a difficult spot for their allocations this year (read Three Bond ETFs For A Fixed Income Bear Market).

This is especially true for those who are in the long term bond ETF space. This corner of the market has been one of the better performers over the past 52 weeks but has been on a serious slump so far in 2012.

Investors had sought this sector late in 2011 when it appeared that we were in for a long malaise as it offered stability during deflation scares. However, now that commodity prices are rising and stocks are also surging, this idea is beginning to fall by the wayside, causing many investors to fly out of long term debt in the process.

This is best manifested in the case of the two ultra long term bond ETFs on the market today, the PIMCO 25+ Year Zero Coupon US Treasury Index Fund (ZROZ) and the Vanguard Extended Duration Treasury Index Fund (EDV). These two products each put up gains of over 40% in the trailing 52 week period but now they are both down double digits in year-to-date terms (read Forget About Low Rates With These Bond ETFs).

In fact, these are the only two bond ETFs—in the unleveraged non-inverse space—that have seen losses exceed 10% on the year. Meanwhile, their gains from the one year time period are still crushing all others in the space by a wide margin; nearly 1,000 basis points separate the two from the next best performing fund in the space.

This should demonstrate just how sharp the reversal has been in the space over the last few months, and how interest rate sensitivity can dramatically impact bond fund returns. Both the products have average durations over 25 years, ensuring that they are usually the biggest winners when rates are falling, but are also among the biggest losers when interest rates are on the rise.

Given this sharp reversal, and the continued move towards marginally higher rates in the short-term, it may be time for investors to consider cycling into other types of securities before any more losses are accumulated. This could be a great idea for those who are worried about more bond losses piling up, or for investors who are dismayed over recent equity performance and would like to position themselves for a reversal in stocks. For these investors, any of the following products could make for interesting choices during this uncertain bond environment:

iPath US Treasury Steepener ETN (STPP)

This note looks to give investors the ability to capture returns from a ‘steepening’ of the U.S. Treasury curve via investments in two year and 10 year T-bills. This technique looks to gain when longer dated bills are seeing rates rise, especially when compared to short term notes (Looking For Safety? Try These Money Market ETFs).

This has been the trend as of late, as short term securities have moved up slightly while longer-term bonds have seen marked increases in their rates. Thanks to this recent move, STPP has been a solid performer and could continue to be if investors demand more from longer term debt holdings.

Thanks to this, STPP has added about 5.8% in the past one month period, including a 5% jump in the past week alone. With this performance, the fund has now added about 4.1% so far this year, making it an interesting compliment to bond heavy portfolios should rates continue to rise in longer dated securities.

PowerShares DB US Inflation ETN (INFL)

Generally speaking, when expectations of inflation are on the rise over the long haul, long dated securities can see their rates go up. This is because investors feel the need to be compensated for the higher risk of inflation with bigger payouts, especially when the Fed seems unlikely to hike rates any time soon.

In order to play this trend, investors could consider INFL for a new way to achieve exposure. The note tracks the DBIQ Duration-Adjusted Inflation Index which looks to capture changes in inflation expectations. This is done by tacking a long position in TIPS while undertaking a simultaneous short position in traditional Treasury bonds (read Ten Best New ETFs Of 2011).

In this strategy, future implied inflation trends are seen by an increase in inflows to TIPS while investors move out of unprotected Treasury bonds at the same time. Given the weak performance of Treasury bonds and the average performance of TIPS this year, INFL has been a solid performer adding about 6.8% in the short-term period.

Additional ETF Options

Beyond the choices outlined above, investors could also consider floating rate bonds or short-term debt. These securities generally have low durations and thus are not very sensitive to interest rate changes. However, it should be noted that these products usually have paltry yields when compared to their long-term counterparts in the space (read Do You Need A Floating Rate Bond ETF?).

As a result, these short duration ETFs are probably inappropriate for those looking for income at this time. This is not unlike INFL or STPP either though as these products do not generally pay out anything to investors and often have higher costs as well.

However, so far in 2012, the ETNs outlined above have been the top performers in the space, suggesting that if you are going to sacrifice yield for safety, you might as well look at either of the notes above for a quality, but often over looked, way to protect against a potential bear market in bond ETFs. This strategy could pay off, especially when compared to floating rate or short-term debt should current trends continue.

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