Worried about Deflation? Go Long Bonds with EDV

Since the financial crisis hit over two years ago, governments all over the world have taken a variety of steps to restore economic growth and investor confidence.  The most popular tactic has been to throw enormous amounts of stimulus money into the economy.  Central banks enhanced this fiscal stimulus with drastic cuts to interest rates.  That’s certainly how the Bush and Obama administrations handled the situation.

While the effectiveness of the strategy can be debated, the result is that short-term interest rates in the U.S. currently hover near zero.  The resulting new liquidity makes many investors think twice about investing in long-term Treasuries.  Financial markets suspect the Federal Reserve will not be shy about raising interest rates when economic growth resumes.

In other words, investors look at interest rates and say “There’s nowhere to go but up.”  This keeps some out of longer-dated Treasuries, an asset class normally viewed as a safe-haven from declining or volatile equity markets.

The problem with raising rates in a sluggish economy is that rate hikes are detrimental to growth.  Since growth in the U.S. is sluggish at best right now, inflation and rate increases may not be as big a danger as some fear-mongers would lead you to believe.

In fact, given the tame economic growth we’ve been seeing, deflation may be more of an issue.  That could mean it’s time to take a look at longer-term bonds.  The Vanguard Extended Duration Treasury ETF (EDV) is one way to exploit deflation.  We previously shed some light on the miniscule returns one can expect in money market funds currently.  EDV could be a compelling bet for investors looking to boost their fixed income exposure.

EDV tracks the Barclays Capital Long U.S. Treasury STRIPS 20-30 Year Par Bond Index.  This index includes “AAA” rated government debt with maturity dates of 20 years or more.  The average duration in the index is 26 years, which means it is supersensitive to interest rate changes.  STRIPS offer a twist on traditional Treasuries in that the interest and principal payments are separate from each other.  Yes, this is a somewhat complex play on bonds, but that doesn’t diminish the potential.

EDV’s performance on a year-to-date basis is something to behold.  While offering an annualized yield of 4.5%, EDV has also delivered capital appreciation of 15%.  That’s a stunning return for a bond fund.  Over the same period the S&P 500 is more or less flat, while previously hot niches like emerging markets are in the red.

There’s more to like with EDV.  The expense ratio of 0.14% is hardly noticeable.  Vanguard is known for its low expenses, and EDV is no exception.  That’s just another sign that EDV may have a home in your portfolio.  To use bonds for a potentially deflationary economy, go with EDV.

Disclosure covering writer, editor, publisher, and affiliates: No positions in any of the securities mentioned. No positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) received from, or on behalf of, any of the companies or ETF sponsors mentioned.