TERADAT SANTIVIVUT
Thesis
The iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT) is a fixed income exchange traded fund. The vehicle seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years, namely the IDC US Treasury 20+ Year Index.
TLT is one of the best-known fixed income funds to take a view on the long end of the yield curve. The vehicle has an AUM of over $39 billion and has a very active options chain. With the market implying the Fed might be done with rate hikes this tightening cycle, the question on everybody's mind is around timing of rate cuts and impact on the long end of the curve until then. In our opinion, a rates' environment that has higher rates for longer, will put upward pressure on long end rates to align them with historic term premiums.
While asset managers are increasingly buying long-dated bonds, hedge funds are still massively short:
Hedge Fund Positioning (Bloomberg)
The last 'box' in the above graph (courtesy of Bloomberg), details the flows into 30-year Treasuries. We can see how hedge funds (called 'Leveraged Funds' here) are increasing their short best (the blue line) to record levels.
In this article, we are going to explore the historic relationship between Fed Funds and the long end of the curve and derive an expected move in the long end of the curve and a soft target price for TLT.
TLT Analytics
AUM: $39.3 billion
Sharpe Ratio: -1.18 (3Y)
Std. Deviation: 14.1 (3Y)
Yield: 4.18% (30-day SEC Yield)
Duration: 16.93 yrs
WAL: 25.5 yrs
Expense Ratio: 0.15%
TLT Holdings
The fund holds only fixed rate Treasury securities with a maturity date of over 20 years at the rebalancing date. STRIPs are not included in the portfolio. The fund collateral has an effective duration of 16.9 years, and a weighted average maturity of 25.5 years. Please keep in mind that duration is a measure of bond sensitives to interest rate changes and it represents an easy method to estimate price moves based on interest rate moves:
Duration Impact (BlackRock)
The above chart, courtesy of BlackRock, represents a nice visual illustration of expected price moves based on duration. In our case TLT has a rough duration of 17 years (rounded up), hence for a 100 bps move up in the 20-year rate, the fund is expected to lose -17%.
TLT contains only Treasuries, which are AAA rates securities, hence the only risk factor to consider for this fund is represented by rates.
The fund has only 39 holdings, and its 30-day SEC yield is 4.18%. TLT also has a small positive convexity of 3.81:
"Convexity measures the change in duration for a given change in rates. Positive convexity indicates that duration lengthens when rates fall and contracts when rates rise; negative convexity indicates that duration contracts when rates fall and increases when rates rise.
Source: BlackRock"
Historic Relationship Between Fed Funds and Long Bonds
We are of the opinion that rates will stay higher for longer, which in turn will bring back into play historic term premium relationships in the yield curve. The long end of the yield curve has lagged severely the front end this cycle, but it is now catching up. We feel readers are best served by having a look at other historic occurrence bearing a resemblance to today's environment:
Fed Funds vs 20Y Rates (The Fed)
There are two monetary tightening cycles in the past 25 years that are worth benchmarking against. Namely, the 2000-2001 cycle and the 2006-2007 cycle. In both instances Fed Funds went above the 20-year Treasury rate and stayed there for a prolonged period. Let us have a look at the dynamics for these two past cycles:
Historic Spreads (Author)
During the 2000-2001 cycle rates were higher, at roughly 6%, while the 2006-2007 saw very similar rate levels as today. Interesting to note that the 2000-2001 is the last 'tech bubble' pop in recent history. There are a few important takeaways here:
- Fed Funds can exceed 20-year treasuries yields. While it might be initially seemed counterintuitive given the concept of term premium, the above historic tightening cycles have shown us it can occur.
- On average, the length of time for the inversion is roughly 11 months. With the current cycle having started in December 2022 (when Fed Funds exceeded 20-year rates), a rough estimate would give us an end date close to November 2023
- Surprisingly, the average spread is fairly tight at around 35 bps between the two cycles
- The last item is around timing of the spread - while right after the occurrence of the inversion the spread is tight, the relationship widens afterwards, only to tighten again towards the end of the tightening cycle
We believe this cycle is not going to be materially different than the last ones. In fact, the lower bound of the Federal Funds now is in line with the target Fed Funds in 2007, namely 5.25%. Moreover, we have seen the same spread dynamic - a tight spread starting with December 2022, spread which widened to 110 bps in May and is now coming down as the long end of the curve is moving up.
If the historic relationships hold, and we apply a conservative 45 bps spread, then we should see 20-year yield move up from the current level of 4.45% to 4.8% (5.25%-0.45%=4.8%). That implies a rough move of 35 bps up in spreads from current level. Given the TLT duration of 17 years, that translates into a move lower of roughly -5.95%. From a price standpoint, that gives us around $90/share in TLT.
Conclusion
Treasury yields have moved much higher in the past weeks, on the back of market speculation around higher for longer rates and term premium normalization. In this article, we had a look at 20-year rates and their relationship to Federal Funds from a historic standpoint.
We observed that during the past 25 years we had two similar monetary tightening cycles when Federal Funds exceeded long rates. Both cycles saw average durations of the inversion of roughly 11 months, with an average spread of 35 bps. The current lower bound in the target Federal Funds of 5.25% gives us room for further moves up in 20-year rates from the current 4.45% level.
TLT is a popular fixed income ETF that targets the long end of the curve. The fund has an AUM of $39 billion and an active option chain. With a 17 years duration, the fund has a high sensitivity to interest rate moves and represents a popular vehicle to take a view on long rates. Our analysis shows that the substantial short positions taken by hedge funds in long rates are justified by applying historical term premium spreads, and the implied target price in TLT is $90/share.
