It seems that the Federal Reserve is in an unusual position: while raising interest rates to slow stronger-than-expected inflation, it is now experiencing financial instability concerns. As a result of the collapse of Silicon Valley Bank (SIVB) and the Federal Reserve’s intervention to support bank liquidity, yields sank dramatically across the board.
Nevertheless, numerous factors suggest that the Federal Reserve may maintain elevated interest rates for an extended period, as persistent inflation and recent employment data indicate the need for further tightening measures. We maintain our stance that the Fed will likely continue to uphold high interest rates, or even increase them further. While we still view the iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT) as a solid investment option, we advise caution in light of the recent drastic shift, as it seems improbable that the Federal Reserve will relent this time until inflation subsides or additional weaknesses emerge in the labor market or monetary system.
TLT primarily targets long-term U.S. treasury bonds. The fund’s portfolio consists of U.S. treasury bonds with an average weighted maturity of almost 26 years. The previous year was exceptionally challenging for TLT, as the fund’s value decreased by over 38% due to the Federal Reserve’s assertive interest rate increases and the fund’s heightened sensitivity to rate fluctuations. Considering that we may be approaching the conclusion of this rate hike cycle, we believe it might be a suitable time to begin acquiring shares of TLT. Investors should be ready to average down in case of any price weaknesses.
TLT has underperformed other treasury funds in this bear market
TLT has performed quite unfavorably in the current bear market. The fund has experienced a decline of over 38% since reaching its peak in late 2020 and early 2021. In comparison, its shorter-duration counterparts have weathered the storm more effectively. As illustrated in the chart below, iShares 10-20 Year Treasury Bond ETF (TLH), iShares 7-10 Year Treasury Bond ETF (IEF), and iShares 1-3 Year Treasury Bond ETF (SHY) posted negative returns of 33.92%, 19.95%, and 5.51%, respectively, which outperformed TLT. The downturn in these bond funds over the past couple of years can be attributed to rising inflation and, more significantly, the Federal Reserve’s forceful rate hike last year. Consequently, the Fed fund rate now stands at a level unseen since 2007.
TLT’s underperformance compared to its peers can be attributed to the longer duration treasuries in its portfolio. Currently, TLT has a weighted average maturity of 25.99 years, which is considerably longer than TLH’s 17.59 years and IEF’s 8.43 years. Generally, bond prices with longer durations are more sensitive to changes in interest rates. As a result, TLT’s collection of longer-duration U.S. treasury bonds experienced significantly greater losses than its counterparts in this environment of aggressive rate hikes.
TLT’s long-term total return outperformed other shorter duration treasury funds
Now, let’s examine TLT’s long-term total return. As depicted in the chart below, TLT’s total return of 90.79% since 2007 significantly outperformed TLH’s 72.65%, IEF’s 71.93%, and SHY’s 26.37%. While TLT has the potential to yield superior returns over the long haul, its heightened sensitivity to interest rate fluctuations also renders its fund price considerably more volatile compared to its peers.
We may be near the end of the rate hike cycle
Two primary factors typically influence the bond market. The first factor is the change in interest rates, which we touched upon earlier in the article. Generally, expectations of rate hikes lead to a decrease in bond prices, and the opposite occurs when rate cuts are anticipated. The impact also depends on the duration of the bonds; longer-duration bonds exhibit greater price sensitivity to rate changes.
As we know, last year’s inflation led to the Federal Reserve’s aggressive rate hikes, which may persist this year, albeit at a slower pace, due to ongoing inflation. Consequently, we might continue to see short-term weaknesses in TLT’s fund price. However, we anticipate inflation to eventually subside, as the effects of monetary policy typically take 6 to 12 months to permeate the economy. In the meantime, the Federal Reserve may need to continue raising rates in the short term to keep inflation in check. Once inflation cools off, the Federal Reserve might be able to ease its monetary policy, leading to a decrease in treasury yields and a significant increase in TLT’s fund price. However, this scenario may not unfold until 2024, requiring investors to exercise patience.
The second factor influencing the bond market relates to market psychology. In times of panic, such as the recent collapse of Silicon Valley Bank and several other regional banks, the bond market may react swiftly. If fear prevails, investors may shift funds out of riskier assets like equities and non-investment grade bonds and seek refuge in higher-quality bonds. As U.S. treasuries are often regarded as risk-free assets, they serve as a safe haven for many investors. Therefore, during periods of panic, we can expect U.S. treasury prices to rise. Since TLT solely consists of U.S. treasuries, its fund price will also be positively impacted.
Our strategy: keep buying in 2023
As we might be nearing the end of the rate hike cycle, 2023 could be an opportune time to accumulate shares of TLT. As shown in the chart below, the current 20-year treasury rate of 3.85% is near the higher end of the range observed in the past decade. We believe this rate will eventually decrease to the 10-year average of approximately 2.4%. Thus, any drop in TLT’s fund price should be viewed as a favorable buying opportunity. Investors should capitalize on this and gradually acquire shares, while also being prepared to average down their costs in the event of any price weakness.
The Bottom Line
We reaffirm our bullish stance on TLT and maintain that it is a “Strong Buy.” With the S&P 500 (SPY) trading at a 20.95x P/E ratio amid a recession and the Federal Reserve’s likely unpredictable actions, we continue to favor TLT over the S&P 500.
In fact, considering TLT’s robust price performance, we might even anticipate long-term bonds outperforming the S&P 500 in the upcoming years, based on the aforementioned assumptions. We recommend purchasing TLT at its current prices, up to $120, and potentially employing a dollar-cost averaging (DCA) strategy for the ETF in the following weeks or months. There is a reasonable chance that TLT could experience a near-term decline if the Fed affirms its restrictive monetary policy at subsequent meetings.
TLT Alternatives:
- Vanguard Extended Duration Treasury Index Fund (EDV)
- The Vanguard Long-Term Bond ETF (NYSEARCA:BLV)
- SPDR Portfolio Long Term Treasury ETF (SPTL)
- Vanguard Long-Term Treasury Index Fund (VGLT)
- PIMCO 25+ Year Zero Coupon U.S. Treasury Index Exchange-Traded Fund (ZROZ)
Author：Com21.com，This article is an original creation by Com21.com. If you wish to repost or share, please include an attribution to the source and provide a link to the original article.Post Link：https://www.com21.com/the-ultimate-hedge-against-a-recession-and-interest-rate-reductions.html