Investors Fleeing Treasury ETFs (SHY, TLT)

The first two months of the year saw money flowing into U.S. government debt ETFs as investors were not scared off by the Fed taper. That trend came to a halt quickly as investors removed $10.3 billion in March from ETFs. That was the largest one-month outflow since December 2010.

The iShares 1-3 Year Treasury Bond ETF SHY was the leader in withdrawals as it lost one-third of its assets under management during the month. The total outflows for the month of March totaled $3.9 billion. The $7.9 billion ETF was the victim of the Fed implying that interest rates will be increased six months after the taper is complete. This suggests the Fed could begin raising rates in 2015. Traders put a 64 percent chance on the Fed raising the benchmark rate in June 2015 for the first time in six years.

As interest rates increase the value of the underlying bonds move in the opposite direction and lose value. The reason for this is that the newest bonds will offer higher interest rates that are more attractive to investors. Investors would prefer to buy the bonds with the higher interest rates and sell the old bonds. Because bond ETFs are a basket of bonds with varying maturities they will underperform during a rising interest rate environment.

During the first two months of the year U.S. Treasuries had their best performance since 2010 before the Fed spooked bond investors this month. SHY, which typically moves only a few pennies per day matched its lowest level since September last week.

But, not all bond ETFs are struggling even though interest rates are starting to creep higher again. The iShares 20+ Year Treasury Bond ETF TLT hit the highest level since July 2013 last week. As the Fed begins to increase the benchmark interest rate it will have a more dramatic affect on the short-term bonds versus the longer-date bonds. However, in the end all U.S. Treasury bonds will be affected adversely as interest rates increase and the value of bonds decreases.