TLT: Bonds Offer Favorable Odds Now

seekingalpha06-19

TLT offers exposure to long-term U.S. Treasury bonds with extended duration.TLT provides a favorable return/risk profile under current conditions.The current inflation data and future contracts both ...

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Andres Victorero TLT ETF and inflation data The thesis of this article is pretty straightforward. I will argue that long-term treasury bonds such as those held in iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT) now provide an asymmetric return/risk profile due to both near-term and longer-term catalysts. The key near-term catalyst is cooler inflation. The latest consumer price index data, reported by the U.S. Labor Department on June 12, showed no increase in May 2024, suggesting that inflation has loosened its stubborn grip. More specifically, as shown in the chart below:  The consumer price index held flat in May though it increased 3.3% from a year ago. Both numbers were 0.1 percentage points below market expectations. Excluding volatile food and energy prices, core CPI increased 0.2% on the month and 3.4% from a year ago, compared with respective estimates of 0.3% and 3.5%. Price increases were held in check by a 2% drop in the energy index and just a 0.1% increase in food.   US BLS data  Thanks to the cooler inflation data, bond rates have retreated in tandem. As you can see from the next chart, 30-year treasury rates peaked near 4.75% before the June CPI report and then dropped significantly to the current level of 4.4%. As to be elaborated on later, due to the extended duration of TLT, its prices respond sensitively to bond rates and therefore have enjoyed a sizable advancement since the release of the latest CPI data. Looking ahead, I see a favorable return/risk profile too.   Seeking Alpha TLT ETF: basic information Before diving in, let me introduce the key features of the TLT ETFs that are directly relevant to the remainder of the discussion. As pointed out by the TLT ETF’s description (slightly edited with emphases added by me): The iShares 20+ Year Treasury Bond ETF seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years. It thus provides exposure to long-term U.S. Treasury bonds and targeted access to a specific segment of the U.S. Treasury market. The target access mentioned above refers to the segment with extended duration, as shown in the chart below. As seen, TLT’s weighted average maturity is about 25.64 years as of this writing. The effective duration is about 16.7 years and the average yield to maturity is about 4.5% (quite close to the current 30-year treasury rates mentioned above). Next, I will explain the implication of its extended duration in terms of return potential.   TLT fund description TLT ETF: return projections The effective duration is a measure of the sensitivity of a bond’s price to interest rates. For example, a 10-year bond with a 7-year effective duration would see about a ~7% price advancement if rates decrease by 1%. In the case of TLT, since its effective duration is longer, the sensitivity is greater. As aforementioned, the 30-year treasury rates dropped from a peak near 4.75% before the June CPI report to about 4.4%, translating into a decrease of 0.35%. As a result, the price of TLT should roughly increase by 5.8% (which equals 0.35% times 16.68). You can see this is indeed what has happened. TLT price advanced from a bottom of $89 to the current level of $94, translating into a rise of 5.6%, quite close to the 5.8% estimated above.   Seeking Alpha Looking ahead, I see good odds for bond rates to further decrease. The chart below is a screenshot of the CME Group FedWatch Tool showing the market's current expectation for interest rates based on federal funds futures contracts. The current target rate is in the range of 5.25% - 5.50%. The market expects large probabilities (about 62%) for rates to decrease by 25 basis points at the next Federal Open Market Committee (“FOMC”) meeting on September 18, 2024. Also, note the expectation was a lot lower before the new CPI data. For example, a month ago, the market’s expectation for an interest rate cut of 25 basis points was only 49%.   CME group Looking further, of course, the probabilities for future rate hikes are more diffuse. For example, the next chart shows the probability distribution of rates in September 2025. Time compounds uncertainty. However, two observations stand out in my mind. First, the chance of a rate hike is very low (essentially non-existent) implied by the current federal funds' futures contracts. Second, there are good odds for a substantial rate cut from the current level. For example, the current federal funds futures contracts imply the odds for a rate cut of 1% or more (i.e., to be below 4.25%) is more than 90% by then. Due to TLT’s extended duration, if its yield also decreases by 1% in tandem (highlighted by the green box in the second chart below), its price would enjoy a rally of about 17%. In the meantime, do not ignore the coupon payments (about 2.64 on average if you recall from an earlier chart), which add further upside.   CME group  Author Other risks and final thoughts Besides the asymmetric profile of rate probabilities, another upside catalyst is the possibility of a rate cap. This has been detailed in my earlier article entitled TLT: Lessons From Japan's Bond Cycle and the gist is quoted below. Also, coupon payments from TLT are generally exempt from state and local income taxes in the United States. This benefit stems from the tax-exempt status of the underlying assets - US Treasury bonds held in TLT. Japan’s bond cycle has shown that inflation can become a lower priority when fiscal sustainability becomes a concern. And rate control can follow and push up bond prices, especially long-term bond prices, drastically. In terms of downside risks, interest rate uncertainty is a risk generic to all bonds and bond ETFs. TLT's focus on long-term treasuries amplifies such risks – in both the upside and downside directions. TLT also charges a higher fee compared to some of its close peers, as shown in the next chart below. For example, the Vanguard Long-Term Treasury ETF (VGLT) tracks a similar index to TLT and features a long duration. But VGLT charges a much lower expense ratio of 0.04% (vs. 0.15% for TLT). The SPDR Long-Term Treasury ETF (SPTL) provides an even lower cost of 0.03%. Although TLT features the largest AUM (of $51B) and better tradability. Investors need to consider their style and see if better tradability can justify the higher fee. To reiterate, my thesis is that bond funds such as TLT now provide an asymmetric return/risk profile, judging by the probability distribution of rates implied by future contracts. The future contracts imply dominant odds for a rate cut of 1% or more by September 2025. Other factors, such as fiscal sustainability and rate cap, could lead to even larger cuts. TLT's focus on long-term Treasuries offers potentially higher returns (compared to shorter-term bond funds) if such rate cuts do materialize.    Seeking Alpha","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2444455670"}