ZROZ PIMCO 25 Plus Yr Zero Coupon US Treasury Index ETF

Treasury bond yields are now near their all-time lows as the fears over a possible Greek exit continue to push the investors towards “safe haven assets”. Current benchmark 10-year note yield is not very far from 1.67% level touched in September last year, the lowest level reached in decades.

But the lower the yields go, the more risky these investments become due to potential loss when the interest rates rise. For example, when the Treasury note yield rose from 1.88% at the end of December last year to 2.21% at the end of March this year, bond investors lost substantially.  

Barclays 20 Year Treasury Bond Fund (TLT) was down 6.74% during Q1. This fund had returned 33.60% in 2011. PIMCO 25+ Year Zero Coupon US Treasury Index Fund (ZROZ) lost 12.18% during the first quarter, after a stellar one-year performance (as of March 31. 2012) of 46.98%.

Though bonds preserve nominal principal if they are held till maturity, most retail investors do not hold the bonds till maturity. The interest rates will start going up in a year or two from now, if not earlier, leading to losses in bond portfolios.

Further, with the core CPI now at 2.3% and the 10-year note yielding 1.71%, the loss of principal in real terms is almost guaranteed. Fed’s target for inflation is 2% and with so much liquidity in the system due to Fed’s ultra-low interest policy, the inflation is bound to go up in coming years. Over the past 100 years, the inflation has averaged about 3.5% per year in the US.

The investors putting money in bond ETFs also need to remember that unlike individual bonds which return principal on the maturity date, the ETFs do not have a maturity date and principal value will continue to fluctuate during the period of holding.

It is possible that the yields will touch a new low in the short-term as the bond markets are not acting according to the fundamentals but are driven by fear.  Further, Fed is still a major buyer in the bond market, mainly for the long-term bonds through its Operation Twist program, which will expire in June. But this trend will not continue over a longer-term.

Should the Treasury bonds be left for central banks, sovereign wealth funds and institutional investors? I believe that Income oriented retail investors should look for much better opportunities in  high quality stocks paying stable dividends, investment grade corporate bonds or emerging markets sovereign bonds.

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