Searching for the Best Bond ETF

by: Jon Bernstein

There are currently 15 ETFs with holdings exclusively in U.S. treasury bonds. Which of these are the cheapest, safest, and the most efficient?

First, just to put things into perspective, like the treasury bonds they hold, treasury ETFs are regarded as among the most efficient and the safest instruments in the world. One reason for this is the liquidity of the underlying market. The U.S. treasury market is the world's largest. The U.S. has a staggering amount of debt outstanding: $27 trillion, more than half the size of the international debt market, estimated at about $50 trillion.

Of course, treasury ETFs hold just a miniscule fraction of this overall debt. The largest treasury ETF by market capitalization, iShares Lehman 1-3 Year Treasury Bond (NYSEARCA:SHY), holds about 10 billion in assets. Partly because there are so many treasuries and it is so inexpensive to transact them, treasury ETFs typically have among the lowest expense ratios of any ETFs. The fifteen treasury ETFs are shown below along with their expense ratios:

BIL SPDR 1-3 Month Treasury Bill 0.14 Yes
SHV iShares Lehman Short Treasury Bond 0.15 No
SHY iShares Lehman 1-3 Year Treasury Bond 0.15 Yes
IEI iShares Lehman 3-7 Year Treasury Bond 0.15 No
ITE iShares Lehman Intermediate Term Treasury 0.14 Yes
IEF iShares Lehman 7-10 Year Treasury 0.15 Yes
PST ProShares UltraShort Lehman 7-10 Year Treasury ETF 0.95 No
TLH iShares Lehman 10-20 Yeat Treasury Bond 0.15 No
TIP iShares Lehman TIPS Bond 0.20 Yes
IPE SPDR Barclays TIPS 0.19 Yes
PLW Invesco PowerShares 1-30 Laddered Treasury Portfolio ETF 0.25 No
TLT iShares Lehman 20 Year Treasury Bond 0.15 Yes
TLO SPDR Lehman Long Term Treasury ETF 0.13 Yes
TBT Ultra Short Lehman 20 Treasury ProShares 0.95 No
EDV Vanguard Extended Duration Treasury ETF 0.14 Yes

As the table above shows, with the exception of the two specialized ProShares funds, these funds are not meaningfully distinguishable on an expense ratio basis. Turnover rates can be important for some fixed income ETFs because they describe the frequency of fund transactions subject to dealer markup. Because the cost of these transactions are not included in the ETFs expense ratio, they sometimes surprise investors and can impact its returns. In this case, again because treasury securities tend to be more liquid than virtually any other fixed income vehicle, only an excessively large turnover will impact return. These ETFs all have reasonable turnover rates.

So the decision of which fund to own for most investors will revolve around risk profile. Probably the most important of measure of risk for treasuries is duration, which computes both interest paid and date of principle return. The funds above are sorted roughly by duration, with funds near the top having the shortest duration and funds near the bottom having the highest duration. Average duration will impact how an ETF will respond to changes in interest rates. And interest rates determine the price of the ETF.

There are three basic classes of treasury ETFs: short term, intermediate term and long term. The standard funds are listed below:

SHORT TERM duration (3 yr or below) MID TERM (duration: 3-10 Yr) LONG TERM (duration: 10 Yr )

Which column should an investor own? The ETFs in the third column have a higher duration than the shorter term funds. This typically means that they are more sensitive to interest rate changes, and thus are more volatile. As compensation for this additional risk, holders of these funds can usually expect to be paid a higher yield. In general, long term investors should pick a fund from the second or third column unless they anticipate significant rate increases, in which case the first column by holding down duration will likely outperform. Because of their liquidity, the thick options market and track record, our favorite funds in these three categories are the three iShares benchmarks: SHY, IEF, and TLT.

One of the risks for treasury bond holders is inflation. Inflation erodes the value of a bond fund because (like any debt) when the principle is returned it has become less valuable. There are two bond ETFs that are protected against inflation by holding bonds indexed to the consumer price index [CPI]: TIP, IPE. In the last 20 years the Fed has generally fought inflation with higher interest rates which has hurt all funds including TIPS funds equally. If inflation were accompanied by an unresponsive Fed, these two ETFs would be the ones to own. Which is the better? From a cost point of view these two funds are roughly equivalent. Practically speaking TIP is a better vehicle. As an older and more established ETF has a longer track record, is far larger and its options market is much better developed.

There are also a few more bond Funds that most investors should probably avoid: PLW and EDV.

PLW is actually a great product. It is a ladder-based bond ETF, which means that its treasury holdings are strategically structured by duration. Specifically PLW divides its treasury holdings into 6 groups by duration: 0-5 yrs, 5-10 yrs, 10-15 yrs, 15-20 yrs, 20-25 yrs, and 25-30 yrs. Each group represents just under 17% of the fund. Laddered bond ETFs are superior to other funds because they are diversified across the yield curve. Owning this one fund is like owning the short, intermediate and long-term ETFs listed above in one fund. Typically this steadies returns and reduces risk. PLW tracks a Ron Ryan Index. Ryan is a name-- even an institution-- in bonds. What's not to like? The problem with PLW is not the product, but its popularity. With less than 3 million in capitalization it risks cancellation. Though this is sponsored by PowerShares, the recent discontinuance of Ameristock's equally excellent Ron Ryan products before it for lack of popularity, suggests that this ETF too may risk closure.

EDV is also an interesting ETF. It is the only ETF built on Zeros (Zero Coupon Bonds), which are treasuries stripped of their coupons. The bonds held in EDV in other words do not pay regular interest and are priced purely in terms of a return of the principle. This makes them very susceptible to interest rate changes. In times when interest rates are falling rapidly this is the ETF to own as it will outperform, but long-term investors looking for a bond ETF that will hold up in any environment would probably be better off looking elsewhere.

Finally there are two short bond funds from ProShares: TBT and PST. As the first table above shows these funds have by far the highest expense ratio of any of the fixed income products, and are well above the average even in the company of more expensive specialized ETFs. Designed for traders who are making a bet on interest rates, these funds can be expected to be particularly popular when interest rates are low, when inflation is a concern or when the Fed is expected to raise interest rates. All these things will cause bond prices to fall and these funds to improve. In addition to being short, both funds are leveraged and thus inherently speculative. Because TBT has the longer duration it can be expected to be most susceptible to interest rate movement.

Treasury bonds, and treasury ETFs by extension, are regarded as safe because essentially they are promises issued by the US government and the US government has always followed through on its obligations. Is there any chance the US government will not pay up? Not much. The government owes this money in dollars and because it controls the printing presses for dollars, default is pretty much inconceivable. Worst come to worst the government can always print money to fulfill its obligations to debt holders. Less clear of course is what specifically it will cost an investor to own a piece of this vast market and what that debt is worth in terms of some other asset (such as euro debt or gold). On a macro level, bond prices fluctuate according to this calculation. More technically the cost of any bond ETF (and any individual bond) depends on the interest rate paid by the bond and the length of time (or duration) of those payments.

For domestic holders of treasury ETFs the most important consideration is interest rates and bond duration. Long term investors will generally be served by seeking out ETFs with mediate or longer-term durations.

Disclosure: none