Throughout the year, Wall Street professionals have poured record amounts of money into the world’s largest Treasury exchange-traded fund (ETF) with high confidence that interest rates have reached their peak. However, they have been consistently wrong, facing an estimated $10 billion in losses. Surprisingly, this has not deterred a group of dip buyers who remain undeterred in the face of one of the worst market downturns in recent history.
The main reason for this unwavering optimism is the potential for substantial gains if long-dated government debt experiences even a modest rebound.
Despite indications of lingering inflationary pressures, highlighted by recent data, the iShares 20+ Year Treasury Bond ETF (ticker TLT), with assets totaling $39 billion, has attracted a record $17.6 billion in investments so far this year. This marks the third-largest influx of funds among the more than 3,300 ETFs listed in the United States.
Demand for TLT has grown stronger as the fund’s value has continued to decline, a trend that was particularly evident in Thursday’s trading, compounded by a lackluster auction for 30-year Treasuries. Even with a brief bounce earlier in the week driven by increased demand for safe havens due to Middle East conflict, TLT remains around 50% lower than its 2020 peak.
“TLT is the poster child for betting against the Federal Reserve – you’re essentially wagering that they will drive the economy into a crash and be compelled to reduce interest rates,” remarked Eric Balchunas, a senior ETF analyst. “Those investing in TLT are professionals, not the average investor. It’s a trade for experts.”
Thursday witnessed TLT’s worst one-day performance since May, with a 2.7% drop in its value.
The bullish sentiment is grounded in basic investment mathematics. With 20-year Treasury yields hovering near 5%, a decrease of 50 basis points would yield a total return of over 11% in the next 12 months, as per data from F/m Investments. In contrast, a 50 basis point increase would result in only a 1.1% loss.
“The risk-reward for holding onto long-duration bonds is extremely favorable right now, and it all comes down to bond math,” explained Karissa McDonough, a fixed income strategist at Nottingham Trust. “If we see even a slight decrease in yields for the 10-year, we can talk about a double-digit total return in long bonds, something we haven’t witnessed in years.”
This rationale has enabled investors to maintain their confidence amid a tough year for bond investors, marked by persistent price pressures and increased Treasury supply. According to Bloomberg Intelligence, TLT has burned through more than $10 billion in cash this year, making it the third-largest loss among all ETFs in 2023 based on the fund’s current assets relative to its historical flows.
While the entire Treasury yield curve stands to gain from falling yields, the longer end’s higher duration, which measures a security’s sensitivity to interest rate changes, holds the potential for more significant returns. This potential is not as pronounced in shorter-term debt. With two-year yields at around 5.07%, a 50 basis point increase would still result in a return of about 4.6%, given the current elevated yield levels. In contrast, a 50 basis point drop would yield a 5.5% return.
“The overall rate is substantial enough that the cash flow generates a meaningful return, making it worthwhile to accept the longer-term risk,” said Alexander Morris, President and CIO at F/m. “If you make this investment today, you’ll experience some short-term volatility, amplified by the duration factor, but it’s an opportunity that won’t last forever.”
Bullishness is not limited to fund inflows; it has also extended to the options market. Data from Bloomberg shows that TLT’s open interest for call contracts is near a 20-year high in comparison to bearish puts.
Another reason behind the persistent demand for long-duration bonds is the potential hedge they provide in the event of a U.S. economic recession. A bond rally during such times can help cushion portfolios from losses in the stock market.
Ben Kirby of Thornburg Investment Management explained, “We believe that adding long-duration bonds to a portfolio makes sense today. Typically, during a recession, yields fall by a couple of hundred basis points, depending on how far out the curve you go. This can serve as a hedge for your portfolio to offset equity weakness in that scenario.”
