The Vanguard Long-Term Treasury Index Fund ETF (NASDAQ:VGLT) with $3.36 billion in total assets under management is the second largest bond ETF tracking the price performance of long-term Treasuries. VGLT serves an important role in the market by offering investors exposure to this major bond segment through a low-cost exchange traded fund. Fed rate cuts and a flattening yield curve this year have been positive for fixed-income investments, helping to drive VGLT up 19% in 2019. The move has been a continuation of a secular bull market in bonds, which is being reinforced given current macro conditions. With that said, we think VGLT at current levels has become increasing risky and faces large losses should long-term yields rise from here. This article presents a background on the fund, along with our view on where rates are headed next.
VGLT vs. TLT
First, let's take a look at the composition of VGLT and how it compares to the larger and more widely traded iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT). We think VGLT may be a better option to TLT even as the two funds are technically different. VGLT holds Treasuries with maturities between 10 and 30 years, but is currently 92% invested in 20+ year Treasuries. TLT, as its name implies, is 100% invested at the far end of the Treasury curve. Still, what we point out is that the actual interest rate exposure is very similar as VGLT has a current effective duration at 18.09, while TLT is only slightly higher at 18.36. VGLT's beta over five years at 3.44 compares to 3.65 for TLT. The differences here result in slightly less volatility for VGLT. Although it has performed favorably, we point out below that there is still plenty of risk.
Year to date 2019, the two funds have a nearly identical total return with VGLT up 18.9% compared to 18.91% for TLT. The SPDR S&P 500 ETF (SPY) is added for reference and is up 19.43% this year as of October 10th, 2019. Over the past three-year period, as the chart below shows, VGLT has actually outperformed TLT and is up 14.45% compared to 14.33% for TLT. Since VGLT and TLT are similar enough, we give a preference for VGLT which has a lower expense ratio at 0.07% compared to 0.15% for TLT. While the fee difference is not life changing, why pay more than you have to. Note that all return figures and yields are net of the expense fee.
The other consideration is that VGLT has a slightly higher dividend yield at 2.37% over the trailing 12 months compared to 2.25% for TLT. This is simply a reflection of a different portfolio composition across different Treasury issuances and the timing of allocations.
Analysis And Forward-Looking Commentary
The big question here is where are long-term rates headed? A more uncertain economic growth outlook, the recent Fed rate cuts and expectations of the easing cycle into 2020 suggest that long-term rates can continue to move lower. On the other hand, it's also fair to question how much of the current expectations have already been priced in. We argue that bonds for all intents and purposes are "expensive" at current levels and VGLT has downside.
The 30-year Treasury rate approaching 2% is an unprecedented level, and buying VGLT today is simply a bet that the yield curve will break down lower. The problem we see is that with stocks trading within points of an all-time high even as bonds are essentially pricing in a high chance for a recession, something has to give. There are scenarios regardless on the direction of the economy and the stock market where long-term rates can move higher. Consider the following cases which all could be bearish for the long end of the yield curve and VGLT:
- Fed's "mid-cycle adjustment" is successful in averting a recession. While not our base case, recent news of favorable developments in the U.S.-China trade dispute, it's possible global growth expectations recover leading to improved risk sentiment. While this may the "Goldilocks" setup for stock market bulls, the question becomes what happens to interest rates, and this may be the worst-case setup for VGLT as it could present a broad-based sell-off in bonds. Presumably, the Fed would back off from its commitment of further rate cuts with an eye on inflation expectations which would rise as demand pressures drive commodity prices higher. A steepening of the yield curve from here would lead to large losses for bond investors.
- Fed commits a "policy mistake" whereby it continues to cut rates even as labor market conditions remain firm in an overall stable economic environment leading to an acceleration of inflation expectations. One of the mysteries this cycle has been tepid wage growth which historically drives inflation, which has been absent or at least lower than expected. It's possible that wage growth creeps higher and really gets the proverbial ball going on the CPI index forcing the Fed to take a more hawkish position in monetary policy. In this scenario, we would expect significantly higher levels of rate volatility and a sell-off at the far end of the yield curve given higher long-term uncertainty. Similarly, the Fed could be making a mistake by not cutting rates more aggressively at this point; time will tell. A loss in confidence in the Fed could lead to a structural move high in U.S. interest rates that would be independent of economic conditions.
- The third scenario we propose is one of a stagflation environment where both inflation accelerates higher and the economy falls into a recession. While it's generally assumed that a deceleration of economic activity and an accompanying output gap lead to lower inflation, economic history shows periods where the relationship was reversed. It's at least possible that the economy decelerates even as inflation picks up representing a challenge for policy makers which would be torn between controlling consumer price pressures and supporting growth. A supply side shock in energy prices amid a geopolitical situation could result in such a stagflation environment and investors would likely want to move away from high duration exposure.
It's important for investors to at least acknowledge alternative scenarios beyond the generally accepted outlook, which is currently for tepid yet stable growth with subdued inflationary pressures. Our expectation is for something along the lines of the Fed policy mistake scenario where it becomes apparent either the rate cuts did not occur fast enough or were too aggressive resulting in wide volatility in rates for the year ahead. The combination of still unresolved U.S.-China trade dispute, indicators pointing to a decelerating U.S. and global economy, along with risks in the upcoming U.S. presidential election poses a number of risks to the bond market.
The performance of VGLT going forward will be a reflection of long-term rates, and investors buying the fund here are simply betting that the yield curve will continue to move lower which we think this is a risky proposition. We rate VGLT as a Sell, and recommend reducing portfolio duration exposure lower. Take a look at the fund's prospectus for a full list of risks and disclosure.
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.