Investment Articles (57 lessons)
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How to Use Treasury ETFs to offset a Bear Market

Bonds and U.S. Treasuries are a unique asset class that finds its way into an investor's portfolio in most of the cases. Widely known as a good diversification, bonds often come to the rescue of one's portfolio when the stock markets go downhill.

Unless one follows a very aggressive investing strategy, bonds which are slower to move in comparison to the equities come with a certain level of safety as well, which gives the bonds and Treasuries the nick name as being a "safe haven" asset.

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Despite the simplicity, there is a lot more to investing in a few treasuries or bonds than what it seems. The type of diversification you seek and the eventual protection or hedge you get as a result depends a lot on the type of bonds or treasuries that you own or invest in.

At the end of the day, each asset class is unique and all of them offer a different level of risk and the potential returns you can expect. This balance between the risk and the return will depend on what asset you choose.

The quilt chart below, courtesy of PIMCO gives a quick glimpse into the different types of sectors one can invest in with bonds and you can also see how the returns vary depending on the sector. The type of sector that you choose will depend on your expectations however.

Different bond sectors and their returns (Source - PIMCO)

Different bond sectors and their returns (Source - PIMCO)

Do you want to use Treasuries and bonds just to offset the losses from a bear market? Do you want to use this asset class as a way to earn steady income? The way you answer these questions will determine in which type of bond you will choose.

Are bonds and treasuries more risky than stocks?

Investing in bonds or treasuries is actually less risky than investing in stocks. This is because bonds come with the promise from the issuer to return the face value of the bond or the treasury after the term matures.

What this means for investors is that if they buy a treasury worth $1000 for a 10-year term, they can rest assured that they will get back the $1000 at the end of ten years. Between now and then, treasury investors also get paid what is called as a coupon rate which is the interest one gets for buying the bond or treasury.

Of course, if one factors inflation and other aspects, it can be a completely different story, but sticking to the main theme, treasuries and bonds offer some kind of security which is missing with stocks.

For example, if you invested $1000 in stocks, purchasing shares of one company or even diversified it into buying shares from three or more companies and held your investment for 10 years, chances that either you will make a very good return on your investment, or you could end up losing your investment if the company went bankrupt.

Therefore, in stocks, investors take a risk for which they are rewarded accordingly. Whereas with Treasuries and bonds, the risks are much lesser, thus the returns are also less.

What are Treasuries and Bonds?

Bonds can be issued by just about anyone; from sovereign nations to corporations and even local municipals. Although there is a saying that all bonds are risk free, the truth is that not all bonds or treasuries that you buy are risk free.

Another important distinction to make here is the terminology. While bonds and treasuries can be used interchangeably, the term treasuries are applied only to the longer dated bonds and ones that are issued by the U.S. Department of Treasury only.

Thus, while most bonds in general, such as sovereign, municipal and corporate bonds are at risk of a credit or an institutional default, the treasury bonds are not, as they are backed by the "full faith and credit" of the U.S. government.

This risk is also known as the default risk in bond market terminology, which determines the risk of a potential default from the issuer. Based on this default risk, the markets also price the bond yields (and prices) accordingly.

The 10-year yield on the Greek bonds shown below is one such example where the yields rallied to a whopping 36% in the height of the Greek debt crisis which put the country on a risk of a default on its bonds.

Greece 10-year bond yields (36% interest demanded by bond investors)

Greece 10-year bond yields (36% interest demanded by bond investors)

This seemingly simple aspect is what makes Treasuries stand out among all the types of bonds.

As mentioned earlier in this article, that the level of diversification one needs will depend on the type of bonds or treasuries that one invests it, it is exactly the point that the diversification will change when one invests in a corporate bond versus a 10-year treasury note.

Why invest in bonds or treasuries at all?

Given the fact that Treasuries in particular are backed by the full faith and credit of the U.S. government, the returns one can expect from these assets are very less.

Thus, a common question that is asked is why bother investing in treasuries when they yield very little. The fact is that with the stock markets which are relatively riskier than bonds, the returns are also higher.

This increases the risk of market corrections that can at times come unannounced. Therefore, investors need to look at diversifying their portfolio with an asset class that could offset a bear market in the equities.

This is where the relatively low yielding treasuries come into play as they can help to balance out the losses one might incur during a bear market.

How can treasuries help you to offset losses from a bear market?

With bonds and treasuries, there are two variables in play. The price of the bond or the treasury itself, known as the face value and the coupon rate or the yield which is the interest earned every year for buying the bond or the treasury.

The bond prices and the yields therefore have an inverse relationship.

Because bonds are safe haven assets, investors tend to sell bonds and invest their money in the riskier stock markets which can give higher rate of returns. Therefore when the bonds or treasuries are sold, the prices fall, making the yields more attractive.

Similarly, when the equities are in a bear market, investors tend to sell the stocks and purchase bonds and treasuries. In this scenario, as demand for treasuries or bonds increases, the yields fall.

You can now see that when stocks rally (equities are in a bull market), bond prices fall and when stocks are in a bear market, the bonds and treasuries prices rise.

Is buying treasury ETFs same as buying Treasuries?

An important distinction to make here is that buying Treasury ETFs is not the same as buying Treasuries. The Treasury ETFs are structured in a way that the fund tracks an index of bonds and replicates those returns. Despite the fact that the Treasury ETFs tracks the said portfolio of treasury bonds, they trade on a stock exchange giving them a similarity to trading equities.

One of the biggest differing factors trading a Treasury ETF is that they do not expire or mature. While individual bonds or treasuries have a fixed period maturity, treasury ETFs do not as they have a constant maturity. This constant maturity is based on the weighted average of all the maturities in the bonds that the treasury ETF tracks.

At any point in time, a treasury ETF will have bonds or treasuries that are expiring or reaching maturity. Therefore, treasury ETFs constantly rebalance by purchasing new bonds or treasuries.

While treasury ETFs might be a good way to offset the market decline, they also come with the additional benefit of paying out a fixed income. In most cases, treasury ETFs pay out fixed monthly income due to the nature of the bonds and treasuries that they track.

What are some of the most popular Treasury ETFs?

Among the different Treasury ETFs here are the top three, based on factors such as the assets under management (AUM) and the expense ratio.

1. iShares 1-3 Year Treasury Bond ETF (SHY)

SHY - 5-yr Returns - 0.23 percent

SHY - 5-yr Returns - 0.23 percent

The iShares, 3-7 Year Treasury Bond ETF, (SHY) focuses on the short term Treasuries and has an expense ratio of 0.15% with total assets under management worth $11.044 million. Among the different types of treasury ETFs, the SHY is the most popular due to the short term maturity curve.

The SHY focuses on treasury with less than three years to maturity and therefore offers a balanced risk between interest rate risk and credit risk. SHY is considered to be a safe haven given that the returns are relatively low.

2. iShares 3-7 Year Treasury Bond ETF (IEI)

IEI - 5-yr Returns - 1.05 percent

IEI - 5-yr Returns - 1.05 percent

The iShares 3-7 Year Treasury Bond ETF, IEI has an expense ratio of 0.15% with assets under management worth $6.650 million. The IEI ETF allows investors exposure to the three - seven year maturing Treasuries with little risk of interest rate hike. The IEI also delivers higher returns and overall offers a good cost perspective for investors.

3. iShares 20+ Year Treasury Bond ETF  (TLT)

TLT - 5-yr Returns - 0.03 percent

TLT - 5-yr Returns - 0.03 percent

The iShares 20+ Year Treasury Bond ETF, TLT has an expense ratio of 0.15% with over $6.313 million assets under management. TLT is ideal for investors who want exposure to the longer date Treasuries. TLT is also cost efficient and comes with good liquidity and has full exposure to the U.S. Federal debt.

While there are many more different types of Treasury ETFs the above three offers investors a choice into gaining exposure on the different maturity treasuries which can in return offer a varied level of protection against a declining stock market, while also ensuring that the credit and interest rate risks are properly balanced.

How to use Treasuries in a bear market

Investors who want protection against their portfolio exposure to the equity markets will find that investing in treasuries is a good option. However, this asset allocation needs to be done from the start and not just before one begins to smell a bear market.

There are many different ways to invest in Treasuries. The simplest method is to purchase the Treasuries directly. However, buying or selling can be a bit slow, which brings us to the next alternative, which is to look at the Treasury ETFs. Other examples can also include purchasing Treasury futures as well.

The main benefit of purchasing treasury ETFs is the fact that the markets are liquid enough for traders to enter and exit the market whenever they please. Furthermore, buying and selling treasury ETFs are somewhat similar to buying and selling stocks or equity based ETFs.

In conclusion, treasury ETFs allow traders an easy way to allocate their trading capital. Given the way the Treasury ETFs are structured, investors can easily buy and sell such ETFs as if they were buying and selling stock.

Treasury ETFs gives trader the convenience of price discovery, liquidity and the additional advantage of paying fixed income besides serving as a good hedging tool against a declining stock market. While Treasury or bond ETFs has some strong advantages, there are some factors to bear in mind as well.

Unlike buying treasuries directly where the face value is guaranteed, with Treasury ETFs this is not the case. In other words, when you buy Treasury ETFs there is no guarantee that you will get back your investment amount.

This is because Treasury ETFs are a proxy. Furthermore the fact that there is bon maturity with Treasury ETFs means that investors do not get the same level of protection as someone who directly purchases the Treasuries or the bonds.

Last but not the least, while Treasury ETFs might be a good bet against falling markets, they do suffer under higher interest rate regime which can pull down the value of bonds.

Despite the shortcomings, Treasury ETFs are a good way for investors to build a diversified portfolio that can easily protect their investments against uncertain market conditions. While buying bonds and treasuries outright is a good investment in itself, as far as stock market investors as concerned, Treasury ETFs are a great place to start hedging the risks.

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