As the Great Recession in 2008 threatened the collapse of global financial systems, Treasurys embarked on a rally that had driven the yield on the 30-year Treasury bond to 2.65% as of May 27, 2016. In its initial stages, the rally was fueled by investors seeking safe harbor from falling equities, as well as the quantitative easing program initiated by the Federal Reserve, which resulted in the purchase of approximately $1.75 trillion in Treasury debt from 2009 through 2014.

As the Fed started scaling back its quantitative easing program in 2014, demand for Treasury debt from Japan and eurozone countries, including Germany, Switzerland and Denmark, accelerated due to negative yields on government bonds in those countries. The foreign demand for long Treasurys placed additional upward pressure on bond prices, which further reduced yields. At 2.65%, long Treasurys are paying lower interest rates than those seen during the Great Depression.

Pricing for Zero Inflation

Treasurys have also appreciated due to four years of consecutive declines in the Consumer Price Index (CPI) from 2012 through 2015. Starting with the decline in 2012 to 1.7% from 3% in 2011, the CPI continued to fall through 2015, finishing the year at 0.7%. Whether due to complacency or the assumption that the inflation rate is never going to return to its average of 3% per year since 1926, investors are buying long bonds priced for zero inflation over the next quarter century or longer.

High Risk and Low Reward

In this environment, investors in exchange-traded funds (ETFs) such as the iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT) are accepting a level of risk that is unlikely to be compensated by yield or appreciation over the long term. As of May 26, 2016, the portfolio of the fund, which tracks an index of Treasury bonds with at least 20 years to maturity, had an average weighted maturity of 26.76 years, which makes the fund highly sensitive to interest rate changes. Since 2006, the high interest rate sensitivity has benefited the fund, delivering a 10-year annualized yield of 8.25%.

However, the appreciation in long-dated bonds over the last decade has lowered the distribution yield of the fund to 2.45%. At this level, the fund's high interest rate sensitivity, as measured by duration, has the potential to wipe out years of interest payments on small increases in the yields of long-dated Treasurys, as losses in the price of the fund's shares mount. Duration represents the percentage change of principal on a 1% rise or fall in interest rates. For example, the ETF's duration of 17.2 years indicates a principal loss of 17.2% in the share price of the fund if the yields on long-dated bonds increase by 1%. At this level of rate sensitivity, the equivalent of one year of interest is lost for every increase of seven basis points in Treasury yields.

Moves to Reduce Risk

Due to the extended bond rally resulting in historically low rates, investments at the long end of the yield curve, such as the TLT ETF, pose risks at a disproportionate level relative to potential rewards. For investors seeking to reduce risk related to exposure to long maturities, there are several ETFs with investment-grade bond portfolios paying similar yields with lower durations.

As of May 26, 2016, the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA: LQD) had a distribution yield of 2.77% and duration of 7.9. With duration of 2.8 years, the Vanguard Short-Term Corporate Bond ETF (NASDAQ: VCSH) minimizes interest rate sensitivity while paying a distribution yield of 2.13%.

Investors may also want to consider the Guggenheim BulletShares 2021 Corporate Bond ETF (NYSEARCA: BSCL), which is structured with a maturity date for the return of investors’ capital, similar to a bond. The ETF pays a distribution yield of 2.58%, with a duration of 4.8. The average yield to maturity of bonds in the portfolio is 3.25%, which approximates the total return for investors who hold the fund to its maturity date of Dec. 31, 2021.

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