Treasury ETFs: Are They Really the Safest Exchange Traded Funds?
Exchange traded funds (ETFs) tied to the US Treasury have been available for quite some time now. They offer investors yet another way to diversify their portfolios while also providing a little more flexibility over traditional treasury investments.
Barclays offers 3 treasury ETFs. They are: iSHARES Lehman 20+ Year Tsy Bond Fund (TLT), iSHARES Lehman 7-10 Year Tsy Bond Fund (IEF), and iSHARES Lehman 1-3 Year Tsy Bond Fund (SHY). As you can probably tell by the names, the key difference among them is the maturity date. The maturity date affects the income as well as the day-to-day volatility with shorter term bonds being less volatile than the longer term bonds.
As I wrote in my bond ETF posting, I hold two bond ETFs in my portfolio. I don't have any of the three listed above, my the aggregate bond ETF I do have includes a portion of its holdings in treasuries with varying maturities. My other bond ETF focuses on the corporate bond market. These two ETFs are sufficient for my diversification needs especially since my current age and financial situation allows me to target equity-style investments.
An ETF Topics reader answered a couple of questions folks had:
If you short TLT, doesn't the owner, not you the borrower, get the interest?
If you short any stock (or ETF) you are selling shares owned by someone else, not by you. Before you can short, your broker must first “borrow” the shares from some other customer who is holding the same shares long. However, even though your broker borrowed these shares and sold them on your behalf, the shares still appear in the portfolio of the original (long) owner. The original owner didn't sell them. As far as he's concerned he's still long these shares. He is still entitled to receive any declared dividends on the stock (or, we are really talking “interest,” not dividends, in the case of bond ETF shares). Therefore the short seller is now obligated to pay these dividends to the original (long) owner until he covers his short position (eg, until he buys the shares that were borrowed on his behalf and his broker returns those shares to the original — long — owner).
If you short gold (GLD) you wouldn't have to pay any dividends or interest to the original (long) holder, since gold doesn't earn any dividends or interest. However, most bonds do pay regular interest, and most bond funds (or ETFs) must pass pass that interest on to the share owners in the form of dividends paid to the share owners on a periodic basis. Each time such a dividend is declared, the short seller is obligated to pay the per-share dividend to the original (long) holder, from whom the shorted shares were borrowed. Your broker will simply deduct these funds from your margin account each time a dividend is declared.
Your broker has the responsibility of making sure that you don't get into a position where you cannot cover all your short positions (by repurchasing the shares you shorted and giving them back to the original — long — owner). If it appears to your broker that you might have some problem covering your obligation to replace the shorted shares (probably due to the fact that the shares you shorted INCREASED in price, instead of declining in price, as you had hoped), then your broker will issue a “margin call,” which is an immediate demand that you deposit additional cash into your account. If you are unable or unwilling to immediately deposit this additional cash, then your broker can go ahead and sell shares in your account (or in the case of shorts, buy the shorted shares). These margin calls can force you to liquidate a position at a very unfavorable time, when prices aren't where you want them to be.
For this reason shorting is somewhat dangerous and risky. Most brokers require you to fill out some sort of form attesting that you are an experienced investor who is well acquainted with the risks of shorting.
With long positions the amount of money you can lose is limited to your original investment, because shares can not fall below $0.00. However, with shorts there is no limit to how much you can lose, since, at least in theory, there is no limit to how high the price of a stock can go.
For purposes of taking a position against rising interest rates, is the longer term better than the shorter term?
That depends on how you think interest rates will change in the near vs long-term future. Asking a question like that is similar to asking whether it is better to be long or short on a particular stock. Different people will give different opinions. There is no “scientific” answer (ie, always correct) to such a question. The art of investing involves deciding what you think will happen in the future, and then being right about it.
Long-term interest rates are usually higher than short-term rates, since the lender needs to be compensated for the additional risk of investing his funds over a longer period of time. I can tell you with a fair degree of certainty that the US will probably not experience double-digit inflation in the next year, or two, or even three. But I have no way to know what inflation will be over the next 20 or 30 years.
Generally short-term interest rates (on government T-bills) set the basic “reference point” for all interest rates. Most banks base their “prime rate” on that (and they add a few points to it). Longer-term interest rates generally have a few percentage points more tacked on, for reasons I explained above.
This difference in interest rates (difference between long-term and short-term rates) is expressed by the “yield curve.” You can see the chart here: http://upload.wikimedia.org/wikipedia/en/thumb/1/18/USD_yield_curve_09_02_2005.JPG/800px-USD_yield_curve_09_02_2005.JPG
As you can see from the chart, the longer the borrowing period the higher interest rates go. While this is generally the case, there have also been short periods where we have experienced an “inverse yield curve.” This means that for short periods of time, short-term interest rates have spiked above longer-term rates. This generally happens, for example, when the Fed is trying to tighten up the money supply, by raising short-term rates. Even though short-term rates might spike in response to Fed tightening, longer-term rates might not similarly spike, because bond investors do not perceive an increased risk in (long-term) inflation.
In fact, if the Fed tightens the money supply, while it might cause a temporary spike in short-term rates, it is likely to lead to a REDUCTION in longer-term inflation expectations, since that's exactly what monetary tightening is intended to do. So, long-term rates, instead of risking in tandem with the spike in short-term rates, might actually decline. (This is when we see the “negative yield curve,” where short-term rates are actually higher than long-term rates.)
So, if you believe the fed will need to tighten money in the near future (due to a revival of inflation fears), then it might make sense to short the short-term Treasuries, since the spike in short-term interest rates would cause a decline in the value of the T-bills. (Prices on debt instruments move in the opposite direction from interest rates.)
On the other hand, this spike in short term rates (and resulting decline in the price of short-term debt instruments) might not follow though to the longer-term instruments. In fact, many holders of long-term US debt instruments (such as the People's Republic of China) would very much like to see monetary tightening in the US, since that would tamp down inflation expectations and preserves the value of their longer-term US debt investments.
If you short these short-term debt instruments (let's say instruments which mature in 3 years or less) you of course need to be very careful. The Fed might do exactly what you think it will do, eventually, but it might not happen within the time horizon that you are expecting. If you short a 3-year bond, and short-term interest rates do not rise significantly within that 3 years, then you will not profit from the short (even if short-term interest rates rise considerably in the 4th year). And keep in mind that when you short a bond, you are responsible for paying the interest to the original owner of that bond (the person from whom the bond was borrowed, in order to make it possible for you to short sell it). As far as he's concerned, the bond is still in his portfolio, and he is still entitled to collect his interest, even though the actual bond was “borrowed” from him and sold by you. Since the bond is no longer held by your broker, YOU are now responsible for paying this interest, at least until you buy the bonds (“buy to cover”) and replace them in the original owners portfolio.