U.S. Treasury ETFs: Safety or a Gamble?

The new normal: lower growth rates and lower expected returns, has some investors talking up U.S. treasury bonds and treasury ETFs. But treasury ETFs have appreciated a lot lately. Meanwhile the government is issuing ever more of them. Are U.S. treasuries ETFs a good investment now?

U.S. Treasury bond ETFs made their mark during the worst days of the financial crisis of 2008. Foreign markets, private equity, commodities, even other fixed income products, succumbed to some of the most relentless selling since the depression. Yet during this period, U.S. treasury bonds and U.S treasury ETFs actually gained ground, proving to be negatively correlated with the global market mash up, and the perfect hedge.

The performance of U.S. treasury ETFs has been stellar long before 2008. In fact U.S. treasury bonds outperformed equities for most of the last decade. The chart below compares two benchmark treasury ETFs: the iShares 7-10 Year Treasury Bond (NYSEArca:IEF) and iShares 20 Year Treasury Bond (NYSEArca:TLT) with a US equities benchmark, the Standard and Poors Depositary Receipts (NYSEArca:SPY).

The lower growth rates of the new normal would seem to favor treasury bonds ETFs and other fixed income products. The reason for this is that returns on assets such as equities, commodities, and the like are often tied to growth rates, whereas fixed income is not. But treasury bond ETF holders, like other fixed income investors face another problem: the risk of inflation. Inflation erodes the value of a bond fund because (like any debt) when the principal is returned it has become less valuable.

Inflation is especially important for longer term bond ETFs.

The following table shows the family of U.S. treasury bond ETFs and their expense ratios.

There are three basic classes of treasury ETFs: short term, intermediate term and long term. The standard funds are listed below:

The ETFs in the third column have a higher duration than the shorter term funds. These funds are more sensitive to interest rate changes, more volatile, and thus more risky. As compensation for additional risk, holders of these funds can usually expect to be paid a higher yield. Long term investors should generally pick a fund from the second or third column unless they anticipate rate increases, in which case the first column by holding down duration will likely outperform.

There are two bond ETFs that are protected against inflation by holding 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. If inflation were accompanied by an unresponsive Fed, these two ETFs would be the ones to own. Practically speaking TIP is a best vehicle. As an older and more established ETF has a longer track record, is far larger and its options market is much better developed.

But even owning the short end, owning safest short-term ETFs or owning TIPS bond funds will not protect the investor against another eventuality: a declining dollar. The U.S. has a staggering amount of debt outstanding: $29 trillion, which is more than half the size of the international debt market, estimated at about $50 trillion. Ironically this partly added to the appeal of treasury bond funds during the market meltdown. The sheer size and liquidity of this market makes U.S. treasury ETFs among the most efficient instruments in the world. But this massive amount of debt implies massive supply of dollar obligations. Any serious dollar weakness could cause an exodus of treasuries which will really hurt these funds.

Some of the very things that made U.S. treasury debt safe and attractive during the worst days of the market sell-off now make U.S. debt look risky. No one doubts that the U.S. government will continue to pay its bond holders. No one denies that the U.S. treasury market is vast and efficient. When things get difficult, it is said, investors worry more about return of capital than return on capital. U.S. treasuries have always promised investors safety: return of capital. But in the event of serious inflation and a declining dollar, capital may be returned only in the most technical sense. Owning U.S. treasury debt and U.S. treasury ETFs at these levels look less like a safety hedge and more like a gamble.