With the recent increase in interest rates since May 2nd, and the ensuing drop in my broad laddered treasury ETF (PLW) that I own in my Roth IRA, I thought it would be a good time to evaluate my Treasury bond position.
When I initially bought PLW in October 2008 which was in the heart of the financial crisis, it was my first purchase I had ever made and PLW had been performing well, and I did not do any research into what it owned except for the index description that says "The Index measures the potential returns of the U.S. Treasury yield curve based on approximately 30 equally weighted U.S. Treasury issues with fixed coupons, scheduled to mature in a proportional, annual sequential ("laddered") structure." Therefore, I thought to myself, the fund is performing well, and is diversified across different maturities of bonds, so that sounded good to me, so I purchased PLW. Since that time, I have learned to always look at the holdings of an ETF before I purchase, and thoroughly research an ETF before purchasing.
The first time I looked at the holdings for PLW when I went to the fund page, I was a little surprised when I saw that PLW has a 66% allocation to bonds that have a maturity of 10 or more years. I have known for years that PLW has this duration problem but rates kept falling so I held onto it, and not until the recent spike in rates has it made me realize that I need to do something about it. Therefore, I had to come up with a solution to fix this, and the solution must meet the following two goals:
-Have a lower duration than PLW.
-Have a dividend yield that is close to or higher than PLW.
The first solution I thought of was to replace PLW with another broad treasury only ETF like the PIMCO Broad U.S. Treasury Index ETF (TRSY), which owns treasury bonds across all maturities but focuses allocates less to long-term treasuries and more to short and intermediate term treasuries. Looking through the fund page for TRSY, I saw that it had a shorter duration of 7.30 years vs. 9.96 years for PLW, so that was a plus, but I did not like the SEC 30-day yield of 1.09% where PLW has a 30-day SEC yield of 2.31%. Therefore, I decided to keep this idea on hold if one of my other solutions did not pan out.
The second solution I thought of was knowing that interest rates will eventually rise, and the recent spike in rates is a glimpse of what is to come, I could replace PLW with a shorter specific target duration ETF like iShares Barclays 3-7 Year Treasury Bond ETF (IEI) or iShares Barclays 7-10 Year Treasury Bond ETF (IEF). Like solution #1 both IEI and IEF have a shorter duration than PLW, but both also have a lower yield, IEI having a 0.56% yield and IEF having a 1.58% yield.
The third solution I came up with is to replace PLW with another bond ETF with exposure to treasuries, and other bond asset classes like the PIMCO Total Return ETF (BOND), and pair it with a floating rate ETF to take advantage of rising rates. I looked at BOND and found it has a duration of 4.89 years, which is significantly lower than PLW, and has a 2.45% dividend yield, which is slightly higher than PLW. Then I looked at each of the three floating rate ETFs to see which had the highest yield, and I found that the Market Vectors Investment Grade Floating Rate Bond ETF (FLTR) had the highest SEC 30-day yield coming in at 0.62%.
After looking back through my list of goals and looking at my solutions, I believe solution #3 is the best choice to reduce risk in a rising rate environment, and is the strategy that I will be using to replace my broad treasury bond ETF. There is also some key lessons that people can take from this article:
-The most important lesson you can learn from my article is to always thoroughly research an ETF before you purchase it.
-If you are a new investor like I was when I first bought PLW, find articles about the ETF you are considering on a website like Seeking Alpha, Yahoo Finance, etc to gain knowledge about the ETF and see what other investors think about the ETF.
-Another important lesson you can learn from my article is that when the reason you bought an ETF changes, you must be able to change your investment strategy accordingly. In my case of PLW, I bought it because of the financial crisis and rates were falling which benefited PLW, but now with rates rising, that is a change, so I have to be able to change my strategy to the new market conditions.
Additional disclosure: I plan on initiating a position in BOND, and FLTR, and selling PLW within the next week or two.