SGOV - SGOV: 'T-Bill And Chill'

2023-10-18 09:29:51 ET

Summary

• 1-month and 3-month treasuries are yielding greater than 5%.
• The iShares 0-3 Month ETF has high liquidity, a low expense ratio, and a strong 12-month total return.
• Given sticky consumer price inflation and a hot September retail sales figure, I believe yields remain high through the end of the year.

Following what was a slightly higher than expected September CPI print earlier this month, I made my case for going long the WisdomTree Floating Rate Treasury ETF (USFR) in an article for Seeking Alpha. The core thesis behind that article was as follows:

• Short duration T-bills are now higher than the year over year increase in the consumer price index
• With inflation still well above 3%, the notion that rates could stay higher for longer has credence
• Short term treasuries are well ahead of the dividend yield from the S&P 500
• The S&P 500 is also overvalued compared to historical norms.
• Thus, getting defensive makes sense and one of the best ways to play defense is by hiding out in US treasuries

One point that I made in that article was that I felt it was wise to diversify even a defensive portfolio. As I see it, USFR is a solid hold so long as short term treasuries are yielding 5% or more. In my view, the iShares 0-3 Month Treasury Bond ETF (SGOV) is also a fund defensive minded investors should consider. However, rather than re-write the same article again on equity overvaluation, I'll instead focus on why I believe "higher for longer" is now likely and why an allocation to SGOV makes sense to me in addition to USFR.

What is SGOV?

The iShares 0-3 Month Bond ETF is a fixed-rate fund that tracks the ICE 0-3 Month US Treasury Securities Index. SGOV was launched in 2020 and has since grown to just under $17 billion in assets under management. As of October 16, the weighted average maturity of the underlying bills was 0.1 years - or a little over one month. The average yield to maturity is currently 5.43%.

What makes holding this fund attractive in an investment portfolio is the combination of the short duration of the bills and the monthly dividend from the return on those bills.

With the US 1-month and 3-month T-bills both currently yielding well over 5%, the monthly dividend from SGOV has averaged better than 42 cents per share over the last five months. Given the macro risk from geopolitical uncertainty alone, I think it makes sense to position portfolios defensively. Adding credence to a defensive portfolio strategy is the possibility the interest rates may stay higher for longer after all.

The Case for High Rates

On one hand, I'm just as surprised as anyone that rates have remained this high given the enormous level of government debt. With a public debt load well over $32 trillion, the higher rates go on newly issued US treasuries the more expensive the debt is to service. As the federal government rolls over low-rate debt at higher rates, the interest payments with higher yields can become problematic and we're already seeing a scenario where interest payments on the debt are quickly ballooning.

Again, this exact scenario is why I've been skeptical in the past that rates could realistically stay this high for this long. On the other hand, with the recent downgrade of the US government's credit rating, the idea that US treasury buyers are demanding a higher "risk free" rate for parking capital in government debt does make some sense.

Additionally, if the Federal Reserve's jobs are to maintain full employment and stable prices, the central bank is failing on the latter.

The year over year rate of inflation was still well ahead of trend at 3.7% during the month of September. And this is with high inflation from 2022 that was already elevated well above the baseline trend. Cost of living increases are likely to be an issue in this election cycle and we can look to the numerous labor strikes this year as a possible indication that increases in both wages and prices may not be over yet.

Additionally, consumer spending is still elevated with September retail sales coming in much hotter than expected. Credit card debt outstanding just blew through $1 trillion in August and holiday spending is set to kick into gear. The point is, the fight against high prices does not appear to be over from where I sit. Barring a black swan, which is admittedly entirely possible, I now believe rates will remain high for the next several months.

SGOV vs Floating Rate Funds

Like USFR, SGOV pays out a monthly dividend to shareholders that is designed to give the investor exposure to shorter duration T-bill returns. Structurally, there is a difference between the funds. Unlike the floating rate USFR ETF, SGOV is a fixed rate ETF. As rates have generally continued to rise over the last year, USFR has outperformed both SGOV and even BlackRock's iShares Treasury Floating Rate Bond ETF (TFLO) over the last 12 months.

I do like USFR because I believe rates may actually go higher from here temporarily. But I see SGOV as a nice compliment due to the fixed rate nature of the fund's collateral. If rates continue to rise, USFR will likely outperform. But if rates reverse, SGOV's dividend return at the end of the hiking cycle may hold up a little bit better near the peak as those T-bills mature. Both funds have phenomenal liquidity with AUM figures over $16.8 and $18.4 billion respectively.

Sources: Seeking Alpha, iShares, WisdomTree, State Street

SGOV has the lower expense ratio but also has a 30-day SEC yield that slightly lags USFR's. While SGOV hasn't generated the total 12-month return that floating rate funds like USFR have returned, it has performed well against the SPDR Bloomberg 1-3 Month T-Bill ETF (BIL) which is possibly a better comp than USFR due to it being a fixed rate fund with an identical 30-day SEC yield.

Risks

I'll echo some of the risks from my USFR article here. If treasury yields reverse as more investors rotate out of equities, the total return from funds like SGOV may underperform longer duration fixed rate funds. Even though sticky inflation is part of my justification for holding SGOV, if real yields go negative again, holding US debt rather than assets like gold or other commodities may make less sense.

Since funds like SGOV could theoretically trade at large discounts to NAV in the event of some sort of unforeseen black swan, capital loss is also a possible concern to keep in mind. Finally, there's also the risk of default by the US government. Again, I don't view that as a high risk event, but it's a non-zero percent risk that SGOV holders should consider.

Investor Takeaway

SGOV is really more of a short to mid-term trade rather than a long term investment. At some point yields are going to peak and it will make sense to allocate to longer duration. I'm just not sure we're there yet given the trends in consumer prices and retail sales. That said, I have serious concerns personally about the domestic economy heading into 2024 and any potential slowdown will likely result in rates heading back down. Lower rates would diminish the attractiveness of SGOV.

But to reiterate the larger summary; I think it's a good time to get defensive broadly. I think short duration treasuries are a good way to do that in a diversified portfolio and I like the idea of having exposure to both fixed and floating rate instruments. My personal plan is to sit in SGOV for the next few months while I "T-bill and chill."

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