Taking The Bond Bet

US investors continue to acquire bond ETFs at a record rate. But are they taking on too much risk by getting in at current levels?

According to the recently released National Stock Exchange ETF data report for end-June, American investors are continuing to buy bond exchange-traded funds by the billion.

Net purchases of fixed income ETFs totalled US$20.7 billion for the first six months of the year, over half the total H1 cash inflows of US$40 billion. That’s not quite the record rate of 2009 (when fixed income ETFs attracted nearly two-thirds of net new cash flow), but still an impressive amount, given that bond ETFs represent only 14% of the ETF market as a whole.

In Europe, by contrast, fixed income ETF inflows in the first half of 2010 were pretty much in line with bond funds’ overall share of the market: about a quarter.

The largest bond ETF recipients of investor cash in the first half were two diametrically opposed funds (one long the short end of the maturity spectrum, the other double short the long end).

Ranking third overall in the table of net H1 ETF cash inflows (behind SPDR Gold and Vanguard’s MSCI Emerging Markets fund) was the iShares Barclays Short Treasury fund (NYSE Arca: SHV). Fourth in the table was the ProShares UltraShort Lehman 20+ Treasury ETF (NYSE Arca: TBT), a fund that offers -200% daily exposure to the long end of the treasury yield curve.

If SHV’s returns are nothing to write home about – the fund pays out a tiny yield of 0.18% after expenses – at least its investors haven’t lost money. TBT, by contrast, has performed terribly, losing nearly 30% in the first half of the year as long Treasury yields went down rather than up.

Thinking more broadly about the implications of US ETF investors’ major bond bet, though, it’s worthwhile noting the views of Edward Chancellor of GMO in his latest research piece (registration required).

“Current yields on government bonds in most advanced economies (PIGS excepted) are at very low levels,” writes Chancellor. “Under only one condition – that the world follows Japan’s experience of prolonged deflation – do they offer any chance of a reasonable return. But this is not the only possible future. For other outcomes, long-dated government bonds offer a limited upside with a potentially uncapped downside.”

It’s hard to disagree with this. Taking the bond bet at current yield levels seems a risky wager indeed. Even if you’re a deflationist, rising default risk on longer-maturity government issues might wipe out any gains you might make from projecting low interest rates indefinitely into the future. If you want a safe cash proxy, why not gold?

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