SCHO Schwab Short Term US Treasury

2012 was another good year for the bond markets as the investors continued to pour money into bond funds even though the yields plunged. The benchmark 10-year note ended the year at 1.76%--the lowest closing since 1962 and five-year note yield ended at 0.73%--their lowest year-end closing level since 1986.

However as the two parties managed to arrive at a last-minute compromise to avoid the cliff, bond yield soared while the stocks rallied. The investors have put more than $18 billion in stock funds during the first week of this year—largest inflow since June 2008, when the recession began.

As a result, 10-year note's yield rose to 1.97% earlier this month--its highest level since April but has since moved down to 1.87% as of this morning. (Read: 3 Great ETFs for the Earnings Season)

The minutes of the last FOMC meeting of 2012 released earlier this month further supported the trend as many investors worried that the Fed may end its QE program in 2013. Fed’s massive purchases have been the main factor in keeping the yields at dangerously low levels. Per FOMC minutes “several members now think that it would probably be appropriate to slow or stop purchases well before the end of 2013”.

In all, Fed currently buys about $85 billion of longer-term bonds each month. Further they have pledged to keep the target range for the fed funds rate between 0% and 0.25%-- as long as the unemployment rate remains above 6.5% and medium-term inflation does not exceed 2.5%. Overall the Fed may purchase about $1 trillion in bonds this year.

Fed’s balance sheet has exploded since 2008 but despite significant monetary expansion, inflation has remained benign so far. Bernanke has often said that the aim of the Fed policy is to push the investors to take more risk. On the other hand, may economists have expressed apprehension that large scale asset purchases by the Fed are disrupting market dynamics.

During a speech earlier this week the Fed Chairman downplayed the fears of inflation and reiterated that the economy was still in a “relatively fragile recovery”.

Rates will have to go up eventually but that doesn’t appear to the case anytime soon. Many market gurus have proclaimed deflation of the bond bubble in the last few years but that did not happen.

The idea about the bear market in bonds being finally on the horizon based on one week of fund slows appears to be rather premature. Further it is difficult to predict a market that is driven by the Fed and not by fundamentals. (Read: 4 Best ETF Srategies for 2013)

Also, in the short-term, the movement in yields may follow the developments on the debt ceiling debate. If the negotiations turn nasty, the investors may seek refuge in treasuries again as they did when the lawmakers failed to arrive at an agreement to raise the debt ceiling in 2011 till the eleventh hour. Further if economic growth continues to be lackluster or stalls, the yields may stay low.

While a massive sell-off in the bonds is not likely anytime soon, it is quite possible that the rates may finally start to move up later this year, ending the 30 year down-trend in yields. And as the yields are currently very low, the losses will be very high if the yields go up. So, it may finally be the time when the treasury bond ETF investors should start looking at much better options available to them.

At current valuations, stocks look much more attractive than bonds and will deliver much better returns in the longer-term. Most large US blue chips are sitting on piles of cash and are in a position to increase dividends. Average dividend yield of S&P 500 companies is currently 2.12%. We recommend Vanguard Dividend Appreciation ETF (VIG) which holds stocks of high quality companies that have a record of increasing dividends for at least 10 years. It is Zacks rank 1-‘Strong Buy’ ETF. 

Emerging market sovereign bonds still look attractive even though the spread has tightened in the last couple of years. Many of the emerging countries have better fiscal health than developed countries and further they still have scope to cut rates, whereas interest rates in developed countries are already at historic low levels. Investors should look at J.P. Morgan USD Emerging Markets Bond Fund (EMB) or PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) which yield around 5% currently (Read: Emerging Markets Sovereign Bond ETFs-Safe with attractive yields)

The investors wanting some exposure to US treasury bonds in their fixed income portfolios may consider shorter-end of the curve as the yield curve may continue to steepen this year. Renowned bond guru Bill Gross recommends buying 5-year treasuries and predicts their yield to come down to 0.7% this year. iShares Barclays 3-7 Year Treasury Bond (IEI) charges an expense ratio of 0.15% only but yields 0.87% currently.

Investors betting on bond market collapse using inverse treasury ETFs like ProShares UltraShort 20+ Year ETF (TBT) or ProShares Short 20+ Year Treasury ETF (TBF) need to keep in mind that these ETFs are meant for short-term trading or hedging purpose only. Many of them are designed to achieve their stated performance goal on a daily basis. Over a period longer than one day their performance can differ significantly from their stated daily performance objectives. Further the expense ratios of these ETFs are on the higher side. (Read: Leveraged and Inverse ETFs--Suitable Only For Short Term Trading)

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ISHARS-JPM EM B (EMB): ETF Research Reports
 
ISHARS-BR 3-7TB (IEI): ETF Research Reports
 
PWRSH-EM SVN DP (PCY): ETF Research Reports
 
SCHWAB-US ST TR (SCHO): ETF Research Reports
 
PRO-SH 20+ TBI (TBF): ETF Research Reports
 
PRO-ULS L20+YRT (TBT): ETF Research Reports
 
VANGD-DIV APPRC (VIG): ETF Research Reports
 
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