Thursday, January 28

There Is A Case For Treasuries, But You Have To Be Pessimistic To Make It

Main Thesis

The purpose of this article is to evaluate the iShares Core U.S. Treasury Bond ETF (GOVT) as an investment option at its current market price. This fund covers a popular asset class, U.S. Treasuries, and this is an area that typically performs well when equities fall. Looking ahead to 2021, I see this as a very real possibility, although the stock market has been holding up very well under macro-economic pressure. That said, if conditions deteriorate, GOVT produce a positive return. Further, with record levels of negative yielding debt around the globe, GOVT’s 1% income stream is still relevant.

However, there are risks to buying GOVT now. Duration risk is elevated, given the recent uptick in inflation readings. If this forces interest rates to rise next year, GOVT will probably see a negative total return. Further, equities have shrugged off quite a bit of risk recently. If that story continues, investors in GOVT will be missing out on broader market gains.

Background

First, a little about GOVT. The fund “seeks to track the investment results of an index composed of U.S. Treasury bonds.” It offers investors exposure to U.S. Treasury bonds across a range of maturities, between one and thirty years. GOVT currently trades at $27.43/share and pays a monthly distribution, with a yield of .92% if we annualize the most recent payout. I have been cautious on GOVT for a while, including over the summer. Simply, I saw limited potential for a positive gain. In hindsight, this was an accurate call:

Source: Seeking Alpha

Looking ahead to 2021, the equity markets continue to concern me, so there is some merit to hanging out to treasuries as a hedge against an equity pullback. However, I also see fundamental challenges for treasuries, which forces me to maintain my neutral outlook on GOVT, and I will explain why below.

Treasuries Make Sense If You Expect An Equity Pullback

To begin, I want to consider the why behind why investors would consider treasury positions right now. Clearly, GOVT’s total return has been unimpressive in the short-term, as the “risk on” trade has dominated. For sure, treasuries provide a stable income stream, but that income is quite low, and if the total return is negative, what is the point? Therefore, with this recent performance, why would investors want to start a position now?

A primary reason would be less about how attractive treasuries look, but how unattractive equities look. Despite Covid-19 cases surging in the U.S. and Europe, coupled with elevated unemployment, equities have rallied hard in the second half of the year. To be fair, the economic outlook has improved measurably, and the recent distribution of a vaccine has greatly improved longer term sentiment. However, equities have rallied well beyond expected earnings. This makes current prices quite expensive. In fact, based on a 2-year forward P/E, equities are at a very high level historically, as seen below:

Source: Yahoo Finance

Now, this does not mean equities are going to suddenly correct and, in fact, they could continue rising to new highs. But metrics like this should make investors cautious, at the very least. If it does, one has to wonder, what types of investments perform well when equities fall?

For an answer to this question, let us consider the various correlations certain fixed-income sectors have with the S&P 500. While sectors like investor grade corporate and municipal bonds have low correlations, of the most popular income classes only treasuries have a negative correlation to the S&P 500 over the past five year period. This is shown in the chart below:

Source: RBC Wealth Management

The story here is that treasuries have a good chance of delivering a positive return, if equities move lower. Given how the last few months have been, this is a big if, despite the frothy nature of equity prices. While I personally have been getting cautious, this caution has not been rewarded in the second half of the year. Therefore, investors truly need to consider their own macro-outlook when debating an ETF like GOVT. If current sentiment continues, buying in to GOVT now will not yield much of a return. But if conditions deteriorate, it could be one of the few places to hide out profitably.

Relative Value Compared To Trillions In Negative-Yielding Sovereigns

The other reason for investing in GOVT, in addition to holding assets with a negative correlation to equities, is the income stream. While treasury yields are quite low, they still represent a good portion of many investor’s portfolios, due to their high credit rating. However, as rates have declined this year, so too has GOVT’s distribution. This was a point I touched on back in July, and that story remains consistent today, with GOVT’s monthly payout continuing to push lower. Through Q4, each consecutive month saw a lower income stream stream, which averages out to be just over $.22/share per month. On an annualized basis, this computes to a current yield below 1%, as shown below:

Average Distribution for Q4Annualized Yield Based On Q4 Average
$.022/share.96%

Source: iShares

Given this reality, it should encourage investors to think critically on this asset class. The yield is paltry, and the total return will be minimal if equities move higher. Yet, demand for treasuries has been robust, so why is that the case?

To understand why investors may be drawn to U.S. government treasuries, we have to understand the global environment. Yes, treasury yields are low, both in isolation and on a historical basis. Yet, they remain competitive on a global scale, because many sovereign bonds are actually negative yielding. This means GOVT’s 1% yield actually offers relative value compared to many other government bonds around the world.

While this is not a new concept, it remains especially relevant today because the sheer size of the negative yielding global debt market continues to soar. In fact, the supply of negative yielding bonds just hit a record, as shown below:

Source: Bloomberg

My point here is that treasuries may not seem like an income play, but in relative terms, perhaps they are. With so much negative yielding debt around the globe, a fund like GOVT yielding even 1% is sure to pique some demand going forward. How sustainable that will be longer term is a great question, but for the short term I expect investors to continue to be drawn to this space.

Beware Of Duration Risk

Through the review so far, I have laid out a couple reasons why investors may want to consider GOVT. Yet, when I started this article, I noted I was retaining my “neutral” rating. Therefore, I am obliged to point out a key risk facing the fund, to balance out some of the positive attributes I noted above.

Specifically, I have concerns with duration risk, or interest rate sensitivity. This is not inherently unique to GOVT, as many fixed-income products have seen their duration risk rise over 2020. Nevertheless, it is very relevant to GOVT, as the fund sports an effective duration of almost 7 years, as shown below:

Source: iShares

Essentially, this means GOVT has quite a bit of interest rate sensitivity, and is likely to fall by almost 7% if interest rates rise by one point. Clearly, the income being offered at current levels will not make up for a 7% drop, so investors really need to consider their interest rate outlook before buying.

With this in mind, it would be of interest to readers to know that the inflation rate has been moving markedly higher through 2020. In particular, there was a sharp jump in early December, well above the prior three month-average, that has been sustained as the month has gone on, as shown below:

Source: St. Louis Fed

The takeaway is that we are seeing more inflationary pressure than we have all year. While it is in-line with what we saw pre-crisis, remember that interest rates were higher back in January than they are now. Therefore, it is very likely that if inflation readings continue at current levels, or move even slightly higher, the Fed could be inclined to raise interest rates.

This again reverts back to the risk-reward proposition with GOVT. If inflation backslides, GOVT will probably edge out a positive return. On the other hand, if markets remain bullish and inflation beat expectations, the downside potential for GOVT is considerable. With the yield at only 1% and the duration sitting at an elevated level, the downside risk is probably greater than the upside potential at the moment.

Bottom Line

GOVT continues to tread water, and investors are content for now to ride the momentum plays in equities and higher risk credit products. With those markets looking frothy, treasuries could seem like a smart idea to hedge against the risk of a market correction. However, there are risks to this strategy as well. One is opportunity cost, for GOVT has actually seen a negative return while higher risk products have soared in value. Two, the income stream has been declining, making the trade seem less attractive. Three, duration risk is high, which means investors will not just miss out on gains, but actually lose money, if inflation and interest rates move higher in the new year. Therefore, my outlook on GOVT remains stuck in neutral, and I recommend investors approach this fund very cautiously at this time.

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.

Credit: SeekingAlpha

Leave a Reply

Your email address will not be published. Required fields are marked *