TREASURY MARKET ETFs -- TLT, IEF, SHY

iSHARES Lehman 20+ Year Tsy Bond Fund (TLT)
iSHARES Lehman 7-10 Year Tsy Bond Fund (IEF)
iSHARES Lehman 1-3 Year Tsy Bond Fund (SHY)

To date, I have focused our "ETF Spotlight" section of this newsletter on the stock market-linked ETFs. However, you can also trade the bond market with ETFs (and you will soon be able to dabble in gold as well).

I track four bond market funds. The three I've listed above invest only in bonds issued by the U.S. Government. (I will cover the fourth, which invests in corporate bonds, in a separate Spotlight at a later date.) These bonds are backed by the government and can never default (remember: the government can always print more money to pay you back, which is a nice thing to be able to do). You may also recall that the interest you receive from U.S. Treasury bonds is free from STATE income taxes. You still need to pay tax on any capital gains, and you also are liable to the IRS for Federal taxes on interest payments.

What is the difference among the funds?
The answer to that is just one thing: the time to maturity for the underlying bonds that each fund invests in. For example, TLT only invests in bonds that mature (pay back their principal) in 20 years or more. IEF invests in bonds that mature in seven to ten years. And finally, SHY holds very short maturity bonds -- those that pay off in one to three years.

The longer the time to maturity, the more volatile the price of the fund will be. As you can see from the tables below, the average daily price range for TLT is almost double that of IEF and approaches four times that of SHY. However, these ranges pale in comparison to the typical equity-linked fund.

How much price action is there in the funds?
That does not mean there aren't any opportunities in these funds. TLT has fallen more than -12% in the past month (although it did pay a dividend during that time), yet had risen more than that between early April and mid-June. Both of these moves are probably a bit larger than you'd normally see in this fund, but that's what happens as a bubble inflates and pops!

Please be aware that all three of these funds pay dividends each and every month. TLT and IEF have been paying about $0.35 at the start of each month, while SHY's dividends have been about $0.10-$0.12. If you decide to short any of these funds, then you will need to pay those dividends out of your pocket (in theory, the price of the fund should fall by the amount of the dividends paid, so you won't lose out here).

Do these funds trade in the same direction as the stock market?
I'm glad you asked that question. Historically, stocks and bonds have periodically moved in the same direction, but at other times have moved in opposite directions (depending on where we were in the business cycle). However, that has changed in recent years because money now flows into and out of assets on a regular basis as investors try to find the hot spot in the world of asset allocation. This has meant that as stock prices rose, bonds fell, and as equities tumbled from 2000 to late-2002, bond prices rallied. What this means is that the correlation between stocks and bonds has been negative (as you can see from the tables below). A negative correlation within a portfolio will lower the variability of your returns, but also will lower your overall returns. Depending on your goals, bonds may belong in your portfolio, but the exact mix of stocks/bonds you choose to invest in is something that only you and your investment advisor can decide.

Recently (as in the last month or so) bonds and stocks have seen this negative correlation break down a bit. The sharp rise in bond market yields has started to cause some concerns in the stock market. We burst the stock market bubble in 2000. We burst the bond bubble in June. The housing bubble is next. Fixed-rate mortgages have soared. This is forcing people into adjustable rate mortgages, which bring much higher risk to the homebuyer.

What makes these funds move?
In short: the economy. If you own or are short these funds, then you should make it your business to understand and know what is happening on the economic front. In doing so, the first step should be to keep track of the scheduled release of various key economic data (you can find this data on the web at any major financial data site). The most important items to be aware of are:

• Non-farm payrolls and the unemployment rate, which are usually released the first Friday of every month.
• Fed meetings, where the U.S. central bank announces whether or not it is changing its interest rate policy. There are eight meetings every year.
• Inflation reports, both consumer (CPI) and producer (PPI).
• Retail sales -- most importantly, the government statistic, though you might also care to follow the auto manufacturers reports and the chain store sales as well. There are also weekly surveys that are widely followed during the Christmas selling season.
• ISM/NAPM Reports are regional and national reports on how manufacturers are faring in the way of orders received and shipped, how much they are paying for goods and charging for them, hiring plans, etc. These tend to come out toward the end of the month and are the first bits of information available for that month.
• Regional Fed surveys, the most popular of which is the Philadelphia Fed survey on manufacturing.
• Weekly unemployment claims (Thursday at 8:30AM EST).
• Durable goods orders (big-ticket items like planes, autos, etc.)
• The Beige Book -- released eight times a year, written by the region Federal Reserve banks and used as input to upcoming Fed meetings.

You also need to know what the market is forecasting. Reading a headline such as: "Unemployment rate surges to 6.9%" might make you think that the bond market would rally (bad news for the economy is good news for the bond market). However, if economists had been forecasting an unemployment rate of 7.2%, then the news could actually send the bond market south.

You must also remember one key fact: Prices and yields move in opposite directions. If you read that interest rates rose sharply on a given day, then that means bond prices (and hence, the value of these bond funds) fell. When I talk about a negative correlation between stocks and bonds, I am referring to prices. As stock prices rise, bond prices fall and bond yields rise.

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