Pros and Cons of Bond ETFs

In uncertain times, investors are seeking the relative safety of more the stable bonds and their related ETFs. But choosing the right bonds within the helter-skelter will be the challenge.

Bonds usually receive lower returns compared to stocks because of less risk, but since Jan. 1, 2000, bonds have outperformed stocks by more than 50%, according to The Herald Tribune. One such ETF reflecting this trend is iShares Barclays 20+ Year Treasury Bond (TLT), currently up 36.7% year-to-date, with a yield of 3.93%. Investors may continue to find bonds attractive, since stocks may not return to normal for the time being. However, there are those who think bonds are trotting into “overvalued territory.”

Recent deflation woes have caused conventional government bonds to plummet, but inflation-linked bond yields have been rising, reports Paul Amery for Index Universe. Treasury Inflation-Protected Security (TIPs) real yield rose from .9% in March to its peak of 3.15% on Nov. 21, now currently around 2.6%. One such TIP-related ETF, iShares Lehman TIPS Bond (TIP), is currently up 0.2% year-to-date, with yield of 7.83%. The fall in price of inflation-linked bond indices have shown a rise in real yields.

A way to compare conventional (fixed-rate) and inflation-linked bonds is to calculate the break-even inflation rates for different inflation-linked securities. You take the average annual inflation rate over the life of the bond by the the difference between the inflation-linked bond’s real yield and yield on a fixed rate bond of a comparable maturity.

If the actual inflation rate is higher over the period than the break-even rate implies, the inflation-linked bond should be bought at the expense of the fixed-rate bond. Or vice versa, whichever the case may be. At present, investors may only invest in inflation-linked bonds in the U.K. and the U.S. markets.

Comments

[Rory Litwin:]

I am curious about WIP, which is a fund of international inflation-protected government bonds, or seems to be. Does it work like funds of TIPS? What is the nature of the ex-US gov't bonds that it invests in?

2008 Dec 23 10:26 AM

[puttster:]

Tips should not be pushed as a cure-all. Say inflation and interest rates go up by 5%. Yes your bond will go up by 5% for the inflation but will go down by 50% (5% x duration) because of the interest it pays. TIPS will still leave you exposed 90% to the problem. Not much of a hedge!

2008 Dec 23 04:57 PM