2023-07-04 00:42:41 ET
Summary
- A 2% cut in interest rates is the top 2023 black swan event, according to Eric Robertsen, Chief Strategist at Standard Chartered Bank.
- With treasury bond rates hovering around 4%~5%, lofty equity valuation, and an inverted yield curve, I see this prediction as a very plausible scenario.
- Here I will use the iShares Core U.S. Aggregate Bond ETF and iShares 20+ Year Treasury Bond ETF to illustrate the implications of this scenario.
- Toward the end, we will also use our real portfolio to illustrate how and why we are increasing our allocations towards both intermediate-term and long-term treasury bonds.
Thesis
Eric Robertsen, Chief Strategist at Standard Chartered Bank and also Global Head of Research, made a list of 8 black swan events for 2023. At the top of his list is the possibility that the Federal Reserve might cut rates by up to 200 basis points. According to Robertsen’s reasoning,
…the FOMC has underestimated the significant damage that rising rates in 2023 will cause to the economy. If the US economy enters a deep recession in the first half of the year, the central bank may switch to a more accommodative monetary policy and cut rates by as much as 200 basis points.
With treasury bond rates currently hovering around 4%~5%, lofty equity valuation, and an inverted yield curve, I see this prediction as a very plausible scenario. In the remainder of this article, I will detail my thoughts on all these factors in more depth. I will anchor the discussions with the iShares Core U.S. Aggregate Bond ETF ( AGG ) and iShares 20+ Year Treasury Bond ETF (TLT).
The purpose of using these two specific ETFs is twofold: to make the discussion a bit more concrete and also actionable. After all, most individual investors express their view on the bond market via specific ETFs rather than trading the interest rates (or its derivatives). In particular, the final section will illustrate how we use these ETF funds and their equivalent to construct our own portfolio.
AGG and TLT: basic information
First, a quick introduction to both ETFs in case there are readers new to them. Both AGG and TLT are popular iShares bond funds. As you can see from the chart below, AGG boasts an AUM of over $91B. TLT is a smaller fund in comparison, but still with a sizable AUM of more than $39B. Similar to many other funds in the iShares family, both funds feature a rock-bottom low fee in their own category: AGG charges an expense ratio of 0.03% and TLT charges an expense ratio of 0.15%. I will revisit this point in the final section when I explain how I pick specific ETF funds to construct our own portfolio.
The crucial difference between these two funds is their exposure and duration. AGG is an intermediate bond fund, which means it holds a mix of bonds with different maturities with an average effective duration of ~6 years. In contrast, TLT is an extended treasury bond fund, which means it holds only treasury bonds with long durations. And it has an average effective duration of over 17 years. As a result, they will respond very differently should interest rates indeed go down by 2%, as to be elaborated later.
Lofty Equity Valuation and Attractive Bond Rates
I am a top-down investor, thus I always like to start with a big picture. And I use a simple dashboard (see the next chart below) to get an overall view of the various assets and market sectors. The mechanics of the dashboard is detailed in my earlier articles . It is coded in a Google sheet. You are welcome to download it (via this link: Market Sector Dashboard ).
My key observation here is that currently, the yield spread between equity and bonds is all negative except for the energy sector as seen. The yield spread Z-scores are all negative with many sectors featuring a Z-score close to or below negative 2. To me, this is a clear signal that bonds are now offering a more favorable return adjusted for risks.
Bearing this big picture in mind, we will next evaluate the risk premium of AGG and TLT.
TLT and AGG: credit exposure
Besides the spread yield (which correlates to valuation), I also view the holdings in TLT and AGG to have much lower credit risks than the overall equity market. As stated in their fund descriptions below, TLT only holds treasury bonds (which have zero credit risk if you believe in our government) and AGG holds only investment-grade bonds:
The iShares 20+ Year Treasury Bond ETF ( TLT ) seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years.
The iShares Core U.S. Aggregate Bond ETF seeks to track the investment results of an index composed of the total U.S. investment-grade bond market.
To wit, the next chart shows that the majority of AGG’s holdings (a total of more than 10,000 bonds) are AAA rated. And for TLT, its holdings are much simpler. It only holds 39 bonds as of this writing and all its holdings are in treasury bonds with extended durations. Investors do not have to be alarmed by the small number of holdings in TLT. The credit exposure of a single treasury bond is the same as all treasury bonds. The only reason to hold more than 1 is to tailor the duration to the target of ~17 years.
AGG and TLT: what if rates drop by 2%?
Next, I will analyze the potential returns for AGG and TLT if interest rates do drop by 2%. A bit of bond 101 first (more details can be found in my blog article here ):
The price of a bond changes more sensitively as a function of yield when its maturity is longer (with everything else being equal such as coupon rates). Also, the Fed controls the interest rates in the short-term (like 2 months to about 2 years), but not long-term bond yields. The market dynamics decide the yields for bonds with longer durations. The interest rates can drive changes in bond rates but are not identical to bond yields, a key point we will revisit later.
For bond funds (which are collections of various bonds with different maturities as shown in the chart below), the parameter that controls their interest rate sensitivity is the average effective duration. As aforementioned, AGG is an intermediate bond ETF. It holds a collection of bonds with different maturities, ranging from cash (0 duration) to 20+ years. And the average effective duration turns out to be about 6.33 years as of this writing. TLT is a long-term bond ETF because the average effective duration of its holdings turns out to be around 17.45 years as of this writing.
Due to the above difference in their effective durations, they will respond very differently to rate changes as displayed in the next two charts. The first chart was made for AGG based on its effective duration quoted above and its weighted average coupon rates of 2.93% (according to its iShares website ). As seen, if its yield indeed decreases by 2% (highlighted by the green box), its price would enjoy a 15%+ appreciation. And bear in mind that it also provides 2.93% of coupons per year at the same time. The 2 nd chart shows the price response of TLT. Similarly, its price would rally if rates drop, but to a much larger degree. To wit, if its yield does drop by 2%, TLT would enjoy a price appreciation of almost 45% (again, the coupons would add a bit of extra return here too).
Even if the black swan does not occur, I see little room for bond rates to further go up from here. As argued in my earlier article :
At a very fundamental level, in the long term, treasury bond rates cannot rise above long-term inflation or GDP growth. Our government has been relying on inflation and GDP expansion to inflate away and outgrowth its debt obligations for decades in the past. And it will (it will have to) continue doing so.
If you subscribe to this argument, the current treasury rates of 4~5% are close to the long-term target rates already. As such, I see the return/risk profile in bonds (either treasury bonds like TLT or investment grade bonds like AGG in particular) as quite asymmetric under current conditions.
Risks and final thoughts
Finally, risks. The main risk is inflation risk in my view under current conditions. The risk comes from two directions. Firstly, if inflation stays at its current level (which is relatively high compared to the historical average), the purchasing power of money falls. And the coupons investors receive from their bond holdings will be worth less. Secondly, if current inflation persists or even climbs again, it can cause interest rates to stay at current levels or rise in tandem, which can depress the prices of bonds as discussed earlier. As mentioned earlier, I see zero credit risk for TLT. But some of the holdings in AGG might have credit risks.
However, my overall view is that the return/risk profile is quite asymmetric under current conditions for both TLT and AGG for two main reasons. First, I see the risk premium in the equity market as much higher as analyzed in the second section above. And second, I see interest rates having much more room to go down than to go up as argued in the 4 th section.
Finally, our actual bond holdings are shown in the chart below. The chart is taken from a monthly update for our Investing Group members. As seen, we use EDV as our long-term treasury bond holding. EDV and TLT are exchangeable in almost all aspects, but EDV charges a lower expense ratio of 0.06% compared to TLT’s 0.15%. For intermediate-term exposure, we use VGIT instead of AGG. VGIT and AGG have similar effective duration, but VGIT only holds treasury bonds. Here we like pure treasury bond exposure to counterbalance the equity exposure in the rest of our portfolio.
For further details see:
AGG And TLT: 2% Rate Cut Could Be A 2023 Black Swan