Will the Bond ETF Bubble Burst in 2013?

January 7th at 10:36am by John Spence

It has been a rocky start to 2013 for Treasury bond ETFs. For example, iShares Barclays 20+ Year Treasury Bond (NYSEArca: TLT) couldn’t catch a bid Monday morning even though U.S. stock opened to the downside.

The bond ETF has shed about 4% the past week in the aftermath of the U.S. fiscal cliff deal. Treasury yields also moved up last week after the latest Federal Reserve meeting minutes revealed some officials are worried about the impact of the central bank’s bond-buying programs. There is speculation the Fed could even stop purchasing Treasuries as soon as this year. [Treasury Bond ETFs Still Falling After Jobs Report]

“After three decades of declines, interest rates are near rock bottom, and many Wall Street experts think the bond bubble may be about to burst,” CNNMoney reports. [Risk On: Treasury ETFs Fall More After Fiscal Cliff Agreement]

TLT, the long-term Treasury ETF, has a three-year annualized return of 13.6%, according to Morningstar. The bond fund has outpaced the annualized gain of 11.2% over SPDR S&P 500 ETF (NYSEArca: SPY) over the same period.

The Treasury fund lagged the S&P 500 last year after soaring 34% in 2011. U.S. government debt funds have benefitted from extremely low bond yields due to demand for safe havens in recent years and the Fed’s Treasury purchases. The Fed has pledged to keep short-term interest rates near zero until at least 2015.

‘Global thirst for yield’

“Like it’s been in the case of Japan, low interest rates can go on much longer than expected, but right now it seems that all the stars are aligned for interest rates to rise,” said Jeff Weniger, senior investment analyst at BMO Private Bank, in the CNNMoney report. “But ultimately, whether it happens in 2013, 2014 or 2015 doesn’t matter too much. What matters is that you’re not invested in bonds when they do rise.”

Bond prices and yields move in opposite directions. There is concern that investors who have flooded into bond funds and ETFs will get hurt when rates eventually rise. Still, Treasury yields remain stubbornly low by historical standards despite the recent bounce.

Outside of Treasuries, other bond ETF categories such as high-yield corporates enjoyed a solid 2012.

“We expect the global thirst for yield to remain intact during 2013. However, investors were treated to outstanding bond returns in 2012 that are unlikely to be repeated in 2013,” said Tom Fahey, associate director of macro strategies for Loomis Sayles, in an AdvisorOne report. The math of bond returns “just gets harder and harder” as yields keep steadily declining, Fahey added.

Yields on 10-year Treasury notes last week bumped above 1.9% to their highest level in about eight months.

“The sharp move has come as a shock to many market watchers, who were predicting a banner start to 2013, with wrangling in Washington and worries over the economy likely to keep investors heading to the safety of U.S. government debt. In addition, the Federal Reserve is buying $45 billion of Treasurys each month, they reasoned,” The Wall Street Journal reports.

However, the fiscal cliff agreement has put investors into a more “risk-on” mindset and curbed demand for safe havens such as Treasuries. Investors in both bond and stock ETFs should keep a close eye on Treasury yields in 2013.

“Once again, bond analysts and investors expect Treasury yields, the benchmarks for all U.S. debt, to rise in 2013 as the economy improves and money moves to higher-yielding options,” MarketWatch reports. “That makes sense, but it’s worth remembering: they’ve overshot for the last decade.”

iShares Barclays 20+ Year Treasury Bond

treasury-etf-tlt

Full disclosure: Tom Lydon’s clients own TLT and SPY.

The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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