TLT: A Contrarian Opportunity Despite Rising Inflation

Summary

• With investor focus firmly on rising inflation and economic recovery, contrarian opportunities have emerged at the long end of the bond yield curve.
• The iShares 20+ Year Treasury Bond ETF (TLT) now offers a reasonable yield, particularly relative to U.S. stocks, while offering protection against renewed economic weakness.
• Rising inflation is a threat to the TLT but history has shown that even double-digit inflation rates have failed to drive up bond yields during periods of extreme government debt.
• High levels of private sector debt also suggest that even minor increases in yields could trigger economic stresses and the Fed is likely to continue prioritizing near-term economic activity.

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With investors scrambling over each other to get hold of inflation hedges and participate in the economic recovery, opportunities have emerged at the long end of the yield curve. The iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT) now offers a reasonable yield, particularly relative to U.S. stocks, while offering protection against renewed economic weakness. As the Fed is forced to keep interest rates low in order to prevent a rise in debt costs, the long end of the curve is likely to see downside pressure. While inflation pressures remain firmly to the upside, this is not necessarily a problem for long-term bonds.

The TLT holds U.S. Treasuries of maturities of 20 years or more, with a weighted average maturity of around 26 years, duration of 19 years, and a current yield to maturity of 2.2%. 2.2% may seem like a raw deal considering that long-term breakeven inflation expectations sit at 2.3%, meaning that investors who hold to maturity can be expected to lose money in real terms. However, there is potential for strong capital gains in the event that the yield curve undergoes bull flattening as we expect.

Long End Of The Curve Increasingly Attractive

Bond yields at the long end of the curve reflect expectations of future overnight interest rates. If interest rates are expected to remain low indefinitely, then bondholders will be willing to accept a low yield on long-term debt due to the potential for arbitrage gains from rolling down the curve. Currently, the yield curve is at its steepest level since 2017, with the spread of the 30-year yield over the Fed funds at 229bps, compared to an average of 198bps since 1990. Even though yields themselves are far below their long-term average, the spread over overnight rates is actually historically high.

30-Year USTs And 30-Year Spread Over Fed Funds, %

Source: Bloomberg

The Treasury Needs Real Yields Below Zero

We expect the Fed to keep interest rates at extremely low levels for the foreseeable future in order to keep the government's debt costs under control. In 2020 total interest payments of government debt totaled USD539bn, equivalent to 24% of Federal government revenues despite the fact that interest rates were the lowest levels on record. A 1 percentage point increase in real interest rates would see this figure rise to around 35% all else equal, higher than the 33% peak seen in the mid-1980s when bond yields were at double-digit levels.

We see a number of similarities to the late-1940s when the Fed was forced to fix bond yields across the curve to prevent wartime spending from leading to surging borrowing costs. Back then, the long-term Treasury rate was set at 2.5% and rising government spending saw inflation jump to almost 20% in 1947 resulting in 10-year real yields falling to -17%. This suggests that even amid rampant inflation, there is a clear precedent of the Fed prioritizing keeping debt costs down and we expect history to repeat over the coming years.

Source: Robert Shiller

High Private Sector Debt Another Reason The Fed's Hands Will Be Tied

As noted above, we do not expect the Fed to be particularly concerned with rising inflation as its priority is primarily funding the government. Another priority of the Fed's which will likely prevent nominal yields from rising even in the event of high inflation is the extreme level of private sector debt, particularly at the corporate level.

While it is tempting to think that if, for instance, both inflation and bond yields were to rise by another 100bps, then the impact on the economy would be negligible as real yields would remain at current levels. However, money is not neutral and rising inflation is unlikely to be spread evenly across the economy. Some economic sectors would benefit from higher inflation and thus lower real borrowing costs while others would suffer from lower inflation and higher real borrowing costs. As a result, even a rise in nominal bond yields in line with inflation could rest in credit stresses.

Corporate Debt, % of GDP

Source: Federal Reserve, BEA

Summary

The TLT offers a cheap and liquid vehicle for benefiting from the Fed's dovish policy stance which I expect to remain in place for some time. With a yield to maturity of 2.1%, the TLT is higher yielding than U.S. stocks while providing an excellent hedge against renewed economic weakness. Rising inflation is of course a threat but history has shown that even double-digit inflation rates have failed to drive up bond yields during periods of extreme government debt.

Analyst’s Disclosure: I am/we are long TLT. 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.