By Michael Johnston for ETF DatabaseEarlier this year, with the economic recovery showing signs of sustainability and the printing presses in Washington still red hot from an unprecedented injection of liquidity, many well known and respected investors turned bearish on long-term bonds. But there's an old Warren Buffett mantra that calls for opportunistic investors to be greedy when others are fearful. And sure enough, anyone with the foresight to stock up on long-term bonds when everyone under the sun was predicting them to plummet has been handsomely rewarded. While financial headlines have focused on Europe's woes and the numerous hurdles facing global equity markets, long-term bonds are quietly putting together a record year, thriving off a combination of uncertainty and yield starvation. WHAT WENT WRONG The bear case for long-term bonds was relatively straightforward, and seemingly based on a valid investment thesis. To stave off a depression and stimulate spending, the U.S. Fed slashed interest rates to record lows in recent years. Heading into the new year, anxiety over a surge in inflation was running high after massive injections of capital into the global financial system. It seemed reasonable to predict that CPI would begin to accelerate, forcing the Fed to raise interest rates off record lows. A rally in equity markets -- the S&P 500 gained about 60% during the final 10 months of last year -- gave investors hope that the recovery was off and running and that markets would be able to withstand a rate hike campaign. Because interest rate hikes make existing debt securities less attractive, since investors can get a higher rate from recently issued securities, an inverse relationship often exists between interest rates and bond prices. Long story short: "Inevitable" interest rate hikes spelled disaster for long-term bonds. Fast forward to August. Many long-term bond ETFs have turned in gains of 20% on the year, including an impressive rally of nearly 10% last week. While uncertainty over the outlook for equity markets has certainly been responsible for part of the rush to fixed income, it clearly hasn't been the only factor. On Monday, the PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF ( ZROZ) climbed 5% on a day when many major equity indexes also finished higher. So what is driving long-term bond ETFs higher? For starters, worries about runaway inflation have largely subsided, only to be replaced by a potentially more devastating concern: deflation. Recent CPI reports have shown that prices may be headed lower -- good news for consumers who see their dollar stretch further, but an unwanted development for equity markets already facing a host of other problems.
Deflationary environments can have complex ramifications on financial markets, but investors generally seek out exposure to long-term fixed income securities when CPI begins to slide. That's because the value of a fixed stream of coupon payments increases as prices slide. Another driver behind the long-term bond rally is the scarcity of fixed-income ETF options offering a material current return. The consensus opinion is that the Fed won't start hiking interest rates until the latter part of next year, and perhaps not even until 2012. That means yields on short-term investment grade debt will remain depressed for the foreseeable future, putting investors who rely on their portfolio to provide current returns in a tough position. The Barclays 1-3 Year Treasury Bond Fund ( SHY), for example, has a 30-day SEC yield of 0.40%. The comparable yield for the 7-10 year fund ( IEI) is just 1.46%. But jump to TLT, which has a weighted average maturity of more than 28 years, and that yield climbs to 3.75%. Even if inflation is near zero -- meaning nominal rates equate to real return --these anemic yields don't offer investors much to get excited about. So it's not surprising that many are looking further down the duration curve to pick up a few additional basis points in yield. LONG-TERM BOND ETF OPTIONS Whether you're looking to pick up yield, reduce risk by moving out of equities or deflation-proof a portfolio, long-term bonds can make an intriguing option. There are a number of ETFs offering exposure to this asset class, including the three we have highlighted below: PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF ( ZROZ): This ETF tracks the Bank of America Merrill Lynch Long Treasury Principal STRIPS Index, a benchmark made up of securities representing the final principal payments of U.S. Treasury bonds with at least 25 years remaining to maturity. iShares Barclays Capital 20+ Year Treasury Bond Fund ( TLT): This ETF offers exposure to long-dated Treasuries, generally offering a higher yield and more interest rate risk than government bonds with a shorter time to maturity. Extended Duration Treasury ETF ( EDV): This Vanguard fund tracks the Barclays Capital U.S. Treasury STRIPS 20-30 Year Equal Par Bond Index, a benchmark made up of STRIPS -- a single coupon or principal payment on a Treasury security that has been stripped into separately tradable components -- with maturities ranging from 20 to 30 years.
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