The Vanguard Long Term Treasury Fund (MUTF:VUSTX) is a solid mutual fund with long duration Treasury securities. The expense ratio of 0.20% is higher than I would like to see, but otherwise the mutual fund looks solid. There are two substantial challenges though. Both relate to the yield curve. The 20-year Treasury runs 2.17% and the 30-year Treasury runs 2.58%. The low interest rates result in significantly less interest income and less potential for capital gains.
The 10-year rate in Japan has reached negative values. As of my writing, the ten-year yield was negative 0.05%. These investors are assured a loss on their investment if they plan to hold until maturity. The only potential for gain is interest rates move farther into the negative territory.
The 10-year German rate 0.089%. The trend of exceptionally low yields on ten-year securities in other developed markets creates a challenge for rates in the U.S. to move dramatically higher.
VUSTX is primarily holding the 20 to 30-year Treasuries, but the trend towards exceptionally low interest rates in developed markets remains challenging. This headwind to rate increases should reduce the potential for a substantial loss on Treasuries, but it is still there. The exceptionally weak yields mean an interest rate increase would create a price movement that could outweigh several years of payments.
The portfolio is demonstrated below:
The average effective maturity demonstrates a fairly long portfolio. To be thorough, I'm also including the allocation by the range of years remaining on the securities.
The long duration is one significant reason for the strong performance in the last 16 years. I don't believe it is viable for returns to come close to this level over the next 16 years.
The performance of VUSTX so far this century (since the end of trading on December 31, 1999) has been excellent. I looked at the total returns using dividend adjusted close values to assess the bull market for Treasuries over that period. An investment of $1,000 with all dividends reinvested would have resulted in $3,480 in total value after about 16.25 years.
The exceptional performance of the Treasuries can be traced back to two major sources: interest income and capital gains.
At the end of the last century, the yields were substantially higher than they are now. If an investor was going to buy the Treasuries and hold them to maturity, they would know the approximate yield they were going to earn over that time period. If they were holding zero coupon bonds (to eliminate reinvestment risk) they would know the precise yield to maturity in advance.
The following chart demonstrates the yields on the 20 and 30-year Treasury for December 31, 1999 and for April 7, 2016:
Getting a 7.98% return on the 20 or 30-year Treasury is dramatically easier when the rate is substantially higher. Simply holding the bonds to maturity would suggest around a 6.6% to 6.7% rate of return. However, the total returns here can be even stronger because old bonds sold from the portfolio would sell for a substantial premium to their original cost.
Nearly Impossible to Repeat
This kind of performance for Treasuries over the next 16 years is nearly impossible. Simply holding the Treasuries to maturity now would be expected to provide interest income at a rate of 2.17% to 2.58% per year rather than 6.6% to 6.7%. That one change eliminates about 4% from the potential compound annual growth rate. That is a little over half of the rate of return seen over the last 16 years.
To create a strong bullish market for the U.S. Treasury, I will look at the potential returns if the fund were to keep investing at the current rates for the next 16 years and saw the yields on Treasuries suddenly fall to 0%. This is a little absurd, but it illustrates the point clearly because it allows the Treasuries to be reinvested at the same interest rate and then to reap the entire capital gain from falling yields. Essentially, investors would be compounding at the current rate until the end of year 16 and then yields falling to zero would cause them to immediately recognize a capital gain worth the entire amount of interest that would be due on a portfolio with 50% invested in 20-year Treasuries and 50% invested in 30-year Treasuries. This means the equivalent of 41 years of interest would be collected and the first 16 years benefit from compounding.
Since this could easily confuse many readers, I'll demonstrate the math:
The average yield between the 20 and 30-year Treasury is 2.375%. The expense ratio on the fund is 0.20%. Therefore, investors would expect the investment to compound at a rate of 2.175% if there was no change in the interest rate environment. Compounding at this rate for 16 years can be accomplished by the following equation:
1.02175^(16) = 1.410959 (rounded)
An investment of $1000 would be expected to be worth $1,410.96. Promptly at the end of that 16-year period, we assume that the yield falls to 0% and the fund was still packed with a 50/50 mix of 20-year and 30-year securities. The result is 20-year Treasury increasing in value by 20 * 2.17% = 43.4%. The 30-year Treasuries would increase by 30 * 2.58% = 77.4%. The average increase (remember a 50-50 mix) would be 60.4%. This increase is applied to the latest portfolio value of $1,410.96 to reach $2,263.18.
Even in this fairly absurd scenario which combines the compounding from current yields with the entire potential for capital gains in the future, the 16-year growth would only take the portfolio up to $2,263.18 rather than the $3,480 ending value created over 16.25 years by an investment on December 31, 1999.
Compound Growth Rate Assumptions
Assuming no change in the interest rate environment, investors would expect a mere 2.17% to 2.3% growth rate. Even with substantial capital gains from interest rates going to 0%, returns wouldn't be surpassing 4.48% with a sudden and dramatic increase when the rates collapsed. It is absurd to even hope for the kind of returns generated over the last 16 years.
VUSTX had two sources of income over the last 16 years. Investments in Treasuries initially carried an excellent yield and rewarded investors for holding them with a strong interest payment. The fund also saw gains from interest rates falling lower, but rates are too low for that scenario to repeat. Instead, investors are stuck in a scenario where capital gains are limited and interest payments are weak. Temporary price gains can still be made when long yields fall lower, but the long term "buy and hold" picture is much weaker now. That is unfortunate since retirees still need a solid source of income. This is a solid fund and further declines in yield could send share prices higher, but long-term returns are fueled through interest payments.
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