3 Bond ETFs To Beat Deflation

by: Bruce Vanderveen

Deflation, it's like the unkillable horror-movie monster. Time and again, just when you think it's finally dead, it rears its ugly head to once again threaten global economies.

Over the last 5 years, central banks across the world have unleashed their biggest weapons on the beast: ZIRP (Zero Interest Rate Policy) and QE (Quantitative Easing) - along with optimistic proclamations. It works, but only for a while. Even Japan, which is in the midst of doubling its monetary base, predicts only a little over 1% inflation in the first half of 2014.

Yet, perhaps realizing that non-stop monetary expansion will eventually create more problems than it solves, most central banks (Japan being the exception) now seems to be scaling back asset purchases.

Resurgent Deflation

And, not surprisingly, disinflation and deflation are back in the developed world. A weakening yen, slowing Chinese growth, U.S. tapering (reduced asset purchases by the Fed), European stagnation, and a loss of confidence in emerging markets - all have rekindled deflationary fears.

Since the start of the year, U.S. equities and interest rates have been trending down while bonds, in an unexpected reversal, are trending up. The U.S. 10-year treasury note, possibly the most important economic metric in the world, illustrates this:

Fellow Seeking Alpha contributor, Charles Lewis Sizemore, noted in a recent article that many experts now believe 2014 will be a good year for bonds and fixed income.

Below are 3 bond Exchange Traded Funds (ETFs) which should benefit from the trends we have seen so far in 2014. One is low risk and two are somewhat riskier but higher yielding. All should benefit if interest rates keep falling.

Why ETFs? Well, holding bonds in ETFs is preferable to holding individual bonds or even traditional bond Mutual funds. ETFs, as their name denotes, can be quickly and inexpensively bought or sold on public exchanges. Considering the unpredictability of central banks - that's important.

iShares 7-10 Year Treasury Bond ETF (NYSEARCA:IEF) holds, as the name implies, intermediate-term U.S. treasury debt. The fund invests at least 90-95% of its assets in U.S. government bonds within the 7-10 year maturity range. Currently IEF yields 1.77%. It has a 0.15% annual expense ratio. Credit rating agencies such as Fitch rate U.S. sovereign debt at AAA. See more on IEF here.

Now, much has been made of how U.S. dollar is doomed, how treasuries may be in a bubble, and how long-term rates will soon head up. This may all be true sometime in the future but, for now, rates are falling, treasuries are rising, and the U.S. dollar is strong. Someday, maybe someday soon, these trends may change but for now it's the reality.

Perhaps the best explanation is that Fed tapering is sparking fear overseas and capital (hot money) is now fleeing from risky overseas markets to safety in the U.S. At this point most still believe U.S. treasuries and dollar to be the safest most liquid investment available. The U.S. $100 bill is recognized and accepted most everywhere in the world. No other currency can yet make that claim.

iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:LQD) holds investment grade corporate bonds. LQD invests 90-95% of its assets in investment grade corporate bonds (BBB or higher). Currently LQD has 80% of its bonds in U.S. corporations. LQD holding grades are 17% AA or better, 50% A, and 31% BBB. Maturities are 28% 5 years or less, 15% 5-7 years, 26% 7-15 years, 4% 15-20 years, and 25% 20-30 years. LQD yields 3.85% and has a 0.15% annual expense ratio. See more on LQD here.

LQD is a good bet as long as the U.S. continues to "muddle through" economically. Any rapid acceleration of growth, which seem unlikely at this point, would likely cause interest rates to rise and LQD (along with most fixed rate investments) to fall in value. On the other hand, a rapidly deteriorating U.S. economy will increase corporate bankruptcies and adversely affect LQD.

PIMCO Total Return ETF (NYSEARCA:BOND) If you like bonds but wish to have experts pick them rather than being blindly tied to an index you might consider BOND. This ETF is actively managed by the experts at PIMCO - one of the world's largest bond mutual fund managers. BOND invests at least 65% of its assets in fixed income instruments. Sectors, maturity dates, and credit ratings vary at any given time - depending on what the managers feel is best. Mortgages are part of the mix. Currently BOND yields 2.39% and has a 0.55% expense ratio.

Here is how PIMCO's website describes BOND's strategy and holdings:

The PIMCO Total Return Exchange-Traded Fund is a diversified portfolio of high quality bonds that is actively managed in an effort to maximize return in a risk-controlled framework. BOND invests primarily in investment grade debt securities, and discloses all portfolio holdings on a daily basis. The average portfolio duration normally varies within two years (plus or minus) of the benchmark Barclays Capital U.S. Aggregate Index, and the fund may not use options, futures or swaps. The fund offers a core bond strategy that is designed to capitalize on opportunities across multiple sectors of the fixed income market.

It seems to be working! Although not directly comparable, BOND has outperformed both IEF and LQD since its inception in March of 2012 (see here).

Summary and Conclusion

Deflation is indeed a tough beast to kill. Five years of central bank monetary expansion have just barely kept it under wraps. Now that central bank monetary expansion in slowing in most developed countries disinflation and inflation are once again on the rise.

So far in 2014, capital flight and dis-inflationary trends have U.S. treasuries rising and bonds outperforming. Many professionals believe this will continue into 2014. Bonds are currently outperforming equities and investors looking for capital preservation (with possible capital appreciation) should consider bond ETFs such as the ones profiled above.

A note of caution: Trends can reverse quickly. Bond investors need to keep a close eye on central bank (especially the U.S. Federal Reserve as it controls the world's reserve currency) actions and watch interest rate trends - a good proxy of that is the U.S. 10-year treasury note. If rates once again reverse and start heading up investors should consider exiting bonds positions as prices may quickly fall. Bond ETFs such as above, with their liquidity features, help by making both selling and buying relatively quick and easy.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in BOND over 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.

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