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Treasury ETFs Diverge in Two Fundamental Directions


The initial reaction to Janet Yellen's comments last week bode well for long-term Treasury bonds, but investors should prepare themselves for ongoing shifts.

Janet Yellen really shook things up last week in markets with her remarks about timelines for policy tightening by the Federal Reserve. The initial reaction prompted a sell-off across the board in stocks, bonds, and gold as investors digested the data with uncertainty. However, subsequent trading days saw stabilization in equities and interest rates with the start of a more meaningful divergence in the yield curve.

The real beneficiary of the Fed's statements has been long-term Treasury bonds, as evidenced by the rise in the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT). This widely followed fund has now tested a similar level three times in 2014 and may ultimately break out to new highs on this recent move. Long-term bonds were badly beaten down during 2013 and have come roaring back this year as investors look to hedge their equity bets and rebalance their portfolios to include a slug of fixed income as a safe-haven asset class.

Falling interest rates on the long end of the yield curve haven't translated to intermediate-term bonds in a similar fashion. A look at the iShares Barclays 7-10 Year Treasury Bond Fund (NYSEARCA:IEF) shows how badly they reacted to the Fed's news and changed very little since. Bond investors are clearly worried that the reduction in quantitative easing, combined with the prospect of a rising federal funds rate, will ultimately be bearish for these securities.

Not to be outdone, the short end of the bond market has also had its share of volatility over the last several days as we've seen falling prices in the iShares Barclays 1-3 Year Treasury Bond Fund (NYSEARCA:SHY) as well. This tug-of-war in the yield curve is underscoring the debate about how the market will react when there's no artificial stimulus from the Fed driving bond prices higher. 

My personal belief is that we're going to see some additional shifting of risk among different asset classes and durations as income investors seek to position themselves for the next chapter of this interest-rate saga. The stock market has been less predictable this year, which also adds a layer of complexity to the issue as falling equity prices could be a bid to Treasuries and investment grade debt as a shelter from the storm.
The one thing I would stress is to not get complacent with the same mix of assets -- such as junk bonds and bank loans -- that performed well in 2013. We may see a shift out of credit-sensitive holdings at some point as valuations get stretched to higher-than-normal levels. 

You should be analyzing your fixed-income holdings with respect to sector exposure, price, yield, duration, and any risk management strategies that may be employed by actively managed funds. That way you can get ahead of any problem areas and look to shift your portfolio to new opportunities as they develop in the coming months. 

Read more from David Fabian, Managing Partner at FMD Capital Management:

Investors Should Avoid Adding New Money to Junk Bond ETFs

Financial ETFs Reemerge as Market Leaders

VIDEO: March 2014 Chart Review

Twitter: @fabiancapital
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