When The Bond Bubble Bursts:  iShares 1-3 Year International Treasury Bond ETF – iShares Trust – iShares 1-3 Year International Treasury Bond ETF (NASDAQ:ISHG)

The main idea of the iShares 1-3 year International Treasury Bond ETF (ISHG) is to provide exposure to bonds issued by mature, developed world nations. It is thought that such bonds pose very little risk of default, as well as limited FX risk, given that the currencies of developed world nations tend to be relatively stable from a historical perspective. Unfortunately, trends have not been particularly kind to this ETF since it was launched in 2009. There will most likely be another few years of pain, before circumstances will reverse the current downward trend.

With over $15 Trillion in bonds world-wide yielding negative returns, the obvious question that needs to be asked is who in their right mind would want to hold on to government bonds with negative yields? This is of course the wrong question, because no one is really buying these bonds because of the negative yields, but rather because they expect the current trend of continued appreciation of the bond’s value to gain them a profit. Of course, this can only last for as long as people continue to believe that interest rates will keep sliding downwards, as they have for the past four decades or so. With signs of a global economic slowdown growing, it may not be such a bad bet for coming months, perhaps even years. But then we still need to get back to the original question in regards to who would actually desire to lend the government money and pay the government to take that money. The answer remains that no one really wants to do that, therefore this must be a game of who will be left holding the bag. In other words, the real value of these bonds is far less, and eventually the market will re-balance towards that reality. At that point, assets such as the iShares 1-3 Year International Treasury Bond ETF will get hit very hard, before it will be able to benefit from improving yields.

ISHG Holdings leaning towards sovereign bonds that are considered safe.

Most of the ISHG bonds were issued by the Japanese or EU governments, most of which are considered to be mature, developed economies, with little risk of default.

Data source: iShares.

Aside from a number of Euro zone countries, with questionable fiscal health, such as Italy, Portugal or Spain, as well as potentially Japan which officially has the highest government debt/GDP ratio on the planet, most of the countries on the list are thought to have a very secure sovereign debt situation. Even those Euro zone countries which are seen as being vulnerable in regards to their debt situation are thought to be safe because of the ECB’s ability to intervene if need be. For this reason, ISHG assets are seen as being completely safe, with little risk aside from possible loss of market value. But with interest rate trends having gone lower with reliable predictability in the past forty years or so, market perception tends to be that the trend will just keep going, thus older bonds, with higher yield than newly issued bonds can only appreciate in value.

When and how the bubble might pop.

Because negative or low-yield bonds are not something that any investor really wants to hold on to, unless there are prospects of price gains, it goes without saying that we currently have tens of trillions of dollars worth of bonds on the global market that no one will want to have in their portfolio, once it becomes clear that prospects of price appreciation are gone. The big question is in regards to when and how this will likely occur. One cause I see as being plausible is the eventual collapse of major banking institutions as they find it increasingly difficult to survive within the current low interest rate environment. I recently wrote an article on Deutsche Bank (DB) which highlights the difficulties that banking institutions in the Euro zone in particular are having in producing a profit, given the negative interest rate regime of the ECB. A low interest-driven banking crisis might be just the thing that would force higher interest rates.

There are of course other potential culprits, such as a commodities price shock, which is unlikely to happen in the next few years, given the low demand scenario presented by a slowing global economy. If a commodities shortage scenario were to occur, I think it would be a particularly severe crisis, given all the easy money that would be available to chase after appreciating assets, due to shortages. The much-feared stagflation scenario which people have been worried about since the 2008 crisis pushed interest rates extremely low, would in effect become reality. Central banks across the world would be forced to hike interest rates very aggressively in order to combat runaway inflation.

Regardless of the scenario which will finally put an end to the decades-long trend of declining interest rates, it is unlikely to occur before the next global economic cycle will begin. In other words, we will see a new global economic downturn at some point, most likely within the next few years, and then a new recovery will begin. At that point, I expect interest rates will start to rise, as a global re-balancing towards more normal interest rates will need to take place. Just so we are clear, I am not by any means suggesting that the next recovery will be so robust that central banks will feel at ease to finally normalize interest rates. In fact, the opposite will likely be the case, with the next recovery feeling more like stagnation than a recovery. It is for other reasons, such as the ones I discussed above that central banks will feel the need to act.

IHSG short duration bonds an advantage.

With a dividend yield of only 0.5%, this is by no means an asset that one wants to hold for those returns. Given the fact that it is down just over 1% year to date, it has not been compensating with gains in value either. In fact, since the fund was launched in 2009, it is down almost 20%. One would think that higher interest rates will be a benefit to IHSG, but we should keep in mind that the assets it is currently sitting on will be deeply unpopular once new debt will be issued, with higher yields. Replacing the low interest rate assets with newly-issued bonds will be difficult since there will be few buyers looking to buy into such low interest bearing bonds, when higher interest bonds will be made available.

The one good thing that IHSG has going is the shorter duration of maturity that its bonds come with. At maturity, they have to be redeemed by the issuing entity, which in effect ensures there is a buyer. This will facilitate the relatively quick replacement of low yield bonds for newly issued higher yield bonds. The transition period however may initially be a rough time for investors, at least until enough low-yielding bonds will be flushed out and replaced with higher yielding bonds. In conclusion, this ETF is going to have a rough ride for the next few years, before it can finally experience some better times.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.