What Could Happen To Long-Term Treasury Bondholders If Interest Rates Rise?

Feb.13.13 | About: iShares 20+ (TLT)

Let me just caveat this (my first) article with the fact that I was not alive when long-term U.S. Treasury rates were not in decline. A quick look at the 30 year yield clearly illustrates this sad reality:

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Around my first few birthdays my parents had the foresight to purchase a couple paper series EE bonds from the bank as used to (I'm guessing) be custom for birthdays. Occasionally, when I'm feeling nostalgic I'll pull up the Treasury's Bond Wizard and stare wide-eyed at these little notes' 8.12%, 7.96% and 7.56% yields. While that golden era of paper bonds is certainly gone, the subsequent never ending decline in long-term U.S. Treasury Yields has been a boon to bond ETF holders the market over.

While this seems counterintuitive, it makes fundamental sense. The value of a bond fund is inversely related to the yield on its holdings. When Treasury rates fall, bond prices rise; should Treasury rates rise, we can expect bond prices to decrease. An oversimplified example goes like this, would you rather buy a share of your parents' 8% a year bond or the 2% promise you'll get from the Treasury today?

To illustrate this notion, let's correlate the return of iShare's 20+ Year Treasury Bond ETF (NYSEARCA:TLT) since its inception with the extrapolated Treasury yield for the fund's approximate present 28-yr average maturity holding:

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Notice the near-mirror perfect price correlation (R=0.9957) between bond fund returns and interest rates. This is what's known as "Interest Rate Risk", and the 30 year bull-run on bonds has left current fund holders a little disconcerted. If Treasury rates are at historic lows, should investors be wary of if or when these rates decide to rise? A few of Seeking Alpha's contributors think so (Templeton, Smith).

While it may be true that bond fund prices are welded to interest rates, we mustn't forget that the bonds in these funds' portfolios are still earning a fixed rate. Most funds pay out these additional earnings as dividends; thus exclusive of any taxes, the dividend yields for bond funds are loosely related to the average yield for the underlying bonds themselves. Let's look at this for TLT again:

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Oddly daily movements appear negatively correlated, however the general trend is sympathetic. So now at least we have a pretty solid understanding that even if the "bond-bubble" is set to burst and interest rates are set to rise, bond fund holders are provided (minus management fees) the yield the actual bonds promised. The question on everyone's mind however is what could happen to long term treasury fund holders if Treasury rates increase for the next decade at the same rates they've been decreasing.

It shouldn't be this mysterious. Knowing the Treasury rates' ultra-strong correlation to bond-fund price we should be able to *speculation disclaimer* chart a fund's future market return. In order to determine any future dividend yield we should also be able to adjust for our fund's fluctuating dividend rate. TLT's latest semi-annual report quotes their portfolio turnover at around 46%; this seems rather high to me. Nonetheless this turnover keeps the fund's dividend yield playing catch-up with the current Treasury rates. Using just these modifiers, let's project:

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Not as catastrophic as the popular news might make it seem. Bond fund holders will still gain some income if they keep their eyes shut every time rates spike. This being said, if interest rates do appear to be on the up-and-up, I wouldn't recommend being too reliant on bond funds to provide any sort of competitive inflation-adjusted real yield in the coming future.

Summary: U.S. Treasury Bond ETFs are an excellent way to gain exposure to the bond market. Investors should be fully aware that these funds' market prices are linked inseparably to the current Treasury rate curve and that involves considerable risk. Exposure to the funds' underlying bond yield requires sticking around for the ex-div. dates often amidst an unknowable market future. If long-term treasury yields do happen to about-face this year, there are still upsides to long term Treasury funds.

Disclosure: I 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.