During the credit crisis and subsequent global recession, governments around the world cut key interest rates to record lows and enacted massive stimulus programs, in hopes that they would jump-start the economy. With so much quantitative easing and increases to the money supply, many investors have feared that inflation would come to the markets. The UltraShort 20+ Year Treasury ProShares (NYSE:TBT) became a popular destination for inflation-wary investors. However with the economy continuing to grind in second gear, a new scenario could be taking form, one that could have serious portfolio consequences.
IN PICTURES: Top 6 Uses For Bonds
Specter of Deflation
Most investors understand and can deal with inflation. The idea that prices increase over time is something most portfolios are equipped to handle. Deflation, on the other hand, can be a serious threat. Persistent declining prices can create a vicious spiral of negative outcomes. Falling profits, factory closings, shrinking employment/ incomes and increasing defaults on loans by companies and individuals can occur. What's dangerous about our current situation is the Federal Reserve has already used many of its tricks. With the economy barely trudging along, raising rates could have serious implications and drive the economy back into recession. Analysts are predicting that any rate hikes won't occur until 2011 or 2012. Consumer Price Index measures have been low, demonstrating that the possibility of deflation is quickly becoming more of a concern. With lower rates persisting on the horizon, investors may want to take a look at long bonds over the next few months.
Why Long Bonds
As the Fed allows rates to remain low for the foreseeable future, long maturity bonds begin shine as investments. Stocks generally under perform in deflationary environments, but fixed income shines. Short term bonds, such as the iShares Barclays 1-3 Year Treasury Bond (NYSE:SHY), fall out of favor as investors move to longer maturity bonds. Since their coupon payments are locked in for an extended period of time, these bonds become more valuable as portfolio components. In addition, in deflationary environments, investors do not need to take huge risks with their portfolios to generate returns. Earning 4%, when inflation is zero or prices are declining, can be more than enough.
Long Bond Choices
Adding a touch of long bond exposure to a portfolio might be a good bet for next few months, even though longer term inflation still poses a problem. There are several avenues for investors to pursue in order to get that exposure.
Long-term corporate bonds are generally issued by utilities and industrial companies making large capital expenditures. These include new power plants, telecommunication lines and factories. While there can be cause for concern that deflation can wreak havoc on industrials, the Vanguard Long-Term Corp Bond Index ETF (VCLT) offers exposure to 253 different investment grade bonds across a variety of issuers. Holdings include bonds from Verizon Communications (NYSE:VZ) and Norfolk Southern (NYSE:NSC) and have an average maturity of 25 years. The fund yields 5.51%.
For investors looking for less risk from their deflation hedge, U.S. treasuries are still a valid option. The iShares Barclays 20+ Year Treasury Bond (NYSE:TLT) and the SPDR Barclays Capital Long Term Treasury (NYSE:TLO) represent solid plays on the long end of the government spectrum. The SPDR focuses on bonds with maturities 10 years or older, and the iShares fund starts at 20 years, with the average maturity being 14-28 years, respectively. The long bond SPDR yields 4.46% and the iShares 3.87%. For investors in higher tax brackets, long muni bonds can be accessed through the Market Vectors Long Municipal ETF (NYSE:MLN). The ETF provides a tax-free 4.86% yield.
Treasury STRIPS and zero-coupon bonds are another way to plan against deflation. These bonds are fixed income securities sold at a significant discount to face value and offer no interest payments because they mature at face value. So, for example, an investor would pay $500 and in 20 years receive $1,000. The PIMCO 25+ Yr Zero Coupon U.S. Treasury ETF (Nasdaq:ZROZ) and Vanguard Extended Duration Treasury ETF (NYSE:EDV) offer an easy way to pay these complex fixed income bonds.
The Bottom Line
While, over the longer term, inflation seems to be what's in store for investors. In the short run, the United States could be in for a bout of deflation. Long maturity bonds offer a way to add a deflationary hedge to a portfolio. The proceeding exchange traded funds, along with the iShares Barclay's 10-20 Year Treasury (NYSE:TLH), make ideal holdings during this time. (For related reading, take a look at Deflationary Shocks: Helping Or Hurting The Economy?)
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