From the May 2010 issue of Investment Advisor • Subscribe!

The ETF Advisor: Treasury ETFs Offer Measure of Safety, but Still Carry Risks

When the ups and downs of the stock market get to be too much, when you can't decide whether China or Brazil is a better bet, when you are wondering if states like California can keep paying their bills, there is one place you can put your money that is almost certain to pay you back: U.S. Treasury debt. There are now about a dozen exchange traded funds devoted exclusively to Treasury debt, as well as several others that own zero-coupon Treasury securities, have Treasury Inflation Protected Securities (TIPS), or offer leveraged exposure to Treasuries.

Treasury ETFs are available from five different fund sponsors, and are typically organized as short term, with maturities of one to three years; intermediate term, with maturities of three to 10 years; and long term, with maturities of 10 to 30 years. They typically charge low expense ratios in the 0.1% to 0.2% range, and have anywhere from 10 to 100 individual holdings. As with Treasury securities, interest payments are exempt from state income taxes.

While the U.S. government is thought to be the world's best credit risk, Treasury securities and ETFs that own them do fluctuate in value, and they do have periods of negative returns: the iShares Barclays 20+ Year Treasury Bond Fund (TLT) gave investors a negative 21.5% return in 2009, and the iShares Barclays 10-20 Year Treasury Bond Fund (TLH) had a negative 8.4% return.

To identify attractive Treasury ETFs, we first grouped them by the length of their term, and chose one from each category. One fund, however, the PowerShares 1-30 Laddered Treasury Portfolio (PLW), transcends term categories by owning securities of all different maturities in equal proportions. It does not own Treasury Bills, which have a maturity of less than one year; TIPS; or zero coupon bonds, which are extremely sensitive to changes in interest rates. It pays interest income quarterly, with its most recent distribution equal to 4.29% annually.

Of the funds organized by maturity, Vanguard and PIMCO's Treasury ETFs are both less than one year old, and have yet to attract a significant base of assets or trading volumes, making them less attractive despite similar annual costs and recent performance. While State Street's two Treasury ETFs have been trading since 2007, they are far smaller and less frequently traded than comparable offerings from iShares.

For a short-term fund, which is less sensitive to changes in the interest rate environment but pays a lower yield, the iShares Barclay's 1-3 Year Treasury Bond Fund (SHY), appears to be a solid choice. It has almost $8 billion in assets and currently distributes about 1.17% annually to shareholders. Its 0.15% annual expense ratio is the same as other short-term Treasury ETFs from PIMCO and Vanguard, which are much smaller in size. It is recommended in the Model Asset Allocation Portfolios maintained by the Standard & Poor's Investment Policy Committee.

In the intermediate-term category, the $2.7 billion iShares Barclay 7-10 Year Treasury Bond Fund (IEF) offers a good compromise between current yield and exposure to rising interest rates. Like other intermediate and long-term Treasury ETFs, it, too, suffered a negative return in 2009, 6.38%, but its losses were much less severe than funds with longer terms. Its distribution yield of 3.56% is also significantly higher than the 2.4% paid by the iShares Barclay 3-7 Year Treasury Bond Fund (IEI).

Among long-term Treasury ETFs, the iShares Barclays 10-20 Year Treasury Bond Fund (TLH) compares favorably to the iShares Barclays 20+ Year Treasury Bond Fund (TLT), in that its current distribution yield of 3.83% is not much less than the 4.25% yield of the 20+ fund, but is much less sensitive to changing interest rates. The 10-20 year fund has an effective duration of 9.38 years, according to iShares, while the 20+ fund's effective duration is significantly higher at 14.61 years.


S&P Senior Financial Writer Vaughan Scully can be reached at vaughan_scully@standardandpoors.com. For more information about ETFs and the broad array of services from Standard & Poor's, please visit getmarketscope.com, or call 877-219-1247 for a free trial.
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