Find Shelter in Long-Term Bonds

 | May 08, 2012 | 2:00 PM EDT
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I've been writing for several days about my rather bearish outlook for the short-term, brought on by a fresh wave of uncertainty surrounding the path forward for Europe and unsettling employment data in the U.S.

Though the prospects for the intermediate term are reasonably bright, we've hit a rough patch that has investors reeling in some of the irrational exuberance shown in the form of an impressive rally in the last few weeks.

With major equity markets muddled in a losing streak and clouds of uncertainty lingering, I've been on the lookout for attractive safe havens that could thrive if this turbulence continues. One appealing opportunity exists in long-term bonds, an asset class that has been predicted as the location for a bubble for the past two years but that has defied expectations and posted big gains.

The case against long-term bonds is straightforward: With interest rates at record lows throughout the developed world (and near zero in many markets), rate hikes are inevitable. That will take some of the luster off fixed-income securities with extended durations. But while that development is inevitable, it certainly isn't imminent. We're still a long way from the Federal Reserve even considering a rate hike, and the recent disappointments on the jobs front and in Europe lead me to believe the Fed when it says low rates should persist for several more years.

In other words, it's not quite time to worry about the interest rate risk present in fixed-income securities; rates are going to stay exactly where they are for now. So while there is technically plenty of interest rate risk in these securities, realistically that factor is on hold for the next two years. Meanwhile, long-term bonds offer an attractive safe haven for those looking to pull back from equity market exposure, but not willing to leave cash parked at zero-percent yields while doing so.

There are a couple of interesting exchange-traded funds delivering decent yields at present, and meaningful declines so far in 2012 in the prices of these products make them attractively priced. One option is the Vanguard Long-Term Corporate Bond ETF (VCLT), which holds high-quality corporate debt. The combination of credit risk with interest rate risk is an attractive return opportunity, as VCLT has a dividend yield approaching 4%.

Another interesting product is Vanguard Extended Duration ETF (EDV), which holds STRIPS with maturities ranging from 20 to 30 years. The yield on this product sits at about 5.5%, which approaches the returns investors can expect from junk bonds. But EDV consists only of relatively high-quality bonds; the underlying portfolio consists almost entirely of AAA-rated debt.

A final option is the triple leveraged Direxion Daily 20-Year Plus Treasury Bull 3x Shares (TMF). That fund, which resets exposure at the end of each trading session, offers a relatively cheap and easy way to bulk up exposure to long-term bonds. TMF is a risky proposition in some environments, but a safe place to hide in a storm.

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