This is the second article in a series that explores alternatives to holding long-term government bonds in a portfolio. The first article titled "Strategies for a Rising Rate Environment: Inverse Bond Funds," explored one set of options. This article will continue this discussion and examine alternative bond holdings. Whereas the inverse bond funds strive to have a perfect negative correlation with their targeted bond index, this article will seek to identify other bond options that have a low correlation with the iShares Barclays 20+ Year Treasury ETF (NYSEARCA:TLT). Unlike the inverse bond holdings that zig when the index zags, funds will low correlation may zig or zag to varying degrees when TLT zags.

This first chart is a 3 year correlation matrix of TLT compared to:

- iShares Barclays 10-20 Year Treasury Bond Fund (NYSEARCA:TLH)
- iShares Barclays 7-10 Year Treasury Bond Fund (NYSEARCA:IEF)
- iShares Barclays 3-7 Year Treasury Bond Fund (NYSEARCA:IEI)
- iShares Barclays 1-3 Year Treasury Bond Fund (NYSEARCA:SHY)

**How to read and use this chart:**

The first column is the name of the ETF being used in the correlation, TLT Is the first ETF listed. The next column simply assigns a number to that ETF. TLT is given the #1, the one below it #2 and so forth. Only the # and ETF symbol are used in the top row of the matrix, the name is not listed. The next column is the correlation of TLT with the other ETFs. The upper left cell has a correlation value of 1, that is because TLT is being correlated with TLT, and correlating anything with itself is always 1. The downward sloping diagonal series of correlation values equal to 1 is because those cells represent an ETF correlated with itself.

The other important data is the annualized returns and standard deviations which are the two rows above the matrix. TLT has an annualized return of 12.65% and standard deviation of 14.94%. If TLT is being replaced within a portfolio, those factors must be considered. If TLT is replaced with SHY which has an annualized return of 1.04% and standard deviation of 0.66%, the risk and return characteristics of the portfolio will be dramatically changed. In a transition from a falling rate to rising rate environment however that may be the objective.

**Take home message:**

The important point of this matrix is that as the years to maturity decrease, so does the correlation with TLT (first column of data). This only makes sense because TLT has a much longer duration than the shorter maturity bonds, and their respective ends of the yield curve behave differently to economic news and actions of the Federal Reserve. During a rising rate environment, selecting from the options available from this table, the shorter maturity holdings would be the best alternative to long-term government bonds. It is important to note however that correlation is not a constant. During some periods short term bonds may zig when TLT zigs, and at other times zag when TLT zigs. This graphic highlights how correlation can change over time. The point being that investors need to stay of aware of how their holdings are correlating, and make needed adjustments when their holdings are no longer providing desired diversification benefits, and are trending together in a highly correlated manner. One of the greatest challenges of portfolio management is structuring portfolios to maintain the diversification effect during market crisis. Measuring the changing correlation between holdings is the first step in identifying potential problems.

This chart demonstrates the correlation of TLT with various municipal bond funds, both individual state and national of varying maturities. None of these securities have correlations over 0.60, making them good diversification assets. Municipal bonds offer tax benefits for taxable accounts but may be inappropriate for tax sheltered accounts. They also have risks unique to their location of origin, so correlation, returns and standard deviations should not be the only factors considered when investing in them.

Municipal bond correlation has been trending down over time.

This chart demonstrates the correlation between TLT and inflation protected bonds. Take note that TIPS have 2/3rds the return of TLT, but less than 1/3 the standard deviation. Reward per unit of risk is very favorable for the TIPS, as is the low correlation.

TIPS have also been consistently held their correlation below 0.50.

This graphic highlights the correlation of TLT with investment grade bonds. The highest correlation is 0.51, and they compare favorably on a risk/return basis.

Correlation has also been trending downward.

High yield bonds have a negative correlation, but occupy the opposite end of the credit quality spectrum from U.S. Treasuries. Interestingly, they both have almost identical return and standard deviation values.

High yield has consistently maintained a negative correlation with TLT.

Mortgage backed securities (MBS) have a low correlation with TLT, and compare especially favorably on a risk/reward basis.

Correlation between TLT and MBSs has also been trending lower.

International treasuries and emerging market bonds have negative correlations, but the international treasuries do not compare well on a risk/reward basis. Emerging market bonds compare nicely on a risk return basis, having 5/6th the return with only 1/2 the standard deviation.

Some international treasuries and emerging market bonds' correlation with TLT has been slightly positive at times, but has been trending downward.

This graphic is of relatively new domestic bond funds that have a very short price history, so the correlation statistics are not meaningful. I include them as funds to watch, and as time passes, their correlation statistics will become more meaningful. The one of particular interest is the iShares Floating Rate Note Fund (NYSEARCA:FLOT). This is the only variable rate fund on the list, and should hold up relatively well in a rising rate environment.

This graphic is similar to the above graphic, but of international and global funds with short price histories, and therefore the correlation statistics are not useful. I include them as a watch list, and with time their correlation statistics will become meaningful.

This graphic includes sector bond funds and corporate bonds of various qualities with a limited price history. Once again, the correlation statistics are not meaningful, but these funds are worth putting on a watch list.

In conclusion, as highlighted above, there are many fixed income alternatives investors can use to replace the long term Treasuries in their portfolios if they want to better position their portfolios for a rising rate environment. One tactic would be to sharply reduce the duration of the portfolio, the other would be to diversify away from long term Treasuries by replacing them with bond holdings that have low or negative correlations with them. When doing so, investors should pay attention to the impact such changes would have on the risk/return profile of the portfolio. It is also important to understand that we may be nearing the end of a multi-decade downtrend in interest rates. All historical bond data, correlations and risk/return statistics are based upon that period. All those statistics will likely be reversed in a rising rate environment. Positive gains will become negative, and volatility as represented by standard deviation that added value, will suddenly start to subtract value. Investors must be aware of the dynamics of the fixed income markets when they make their changes. Swapping TLT with an annual return of 12.65% and standard deviation of 14.94% into SHY which has an annualized return of 1.04% and standard deviation of 0.66% may not appear to make sense if just the numbers are considered, but putting those numbers in the context of a market transitioning from a falling rate to rising rate environment, they may make prefect sense.

**Disclaimer:** Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

**Disclosure: **I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.