2023-04-28 14:38:50 ET
Summary
- Historically, I'm no fan of bond investing, in ETF form or otherwise. But 2023 is changing my mind.
- With prospects for stagflation in the economy and stagnation in the stock market, the potential to generate alpha along the US Treasury yield curve has me, dare I say, excited.
- Using the history and current trend in AGG and a Vanguard Intermediate Treasury fund, I make my case for tactical equity investors to look at Treasuries.
Yes, my friends, spring is in the air! I'm not at all referring to the calendar, but to the long-awaited return of a genre of investing I used to despise, but I'm now ready to embrace with a big hug. I'm talking about active management using ETFs to generate total return from US Treasuries. What makes a hard-wired long-short-type ETF asset allocator open his heart to, of all things, Treasury ETFs? A few things:
Rates are finally at a level where we notice them
The 10-year US Treasury yield has more than doubled in the past 12 months, to about 3.5%. That's not enough for me to buy and hold, but it's enough for me to consider that yield in a similar way that an equity income manager looks at their dividend rate: As a decent contributor to total return, but more of an "ante" to get me to manage actively around it, to add alpha.
The Fed has messed everything up.. . when it comes to how investors must view bonds
Here's the iShares Core US Aggregate Bond ETF ( AGG ), which essentially tracks the bond world's equivalent of what the S&P 500 Index means to equity investors. It's the most popular benchmark for professional managers. And when I look at it, I see why my attitude toward bonds is suddenly, shall we say, "activated." Look at that standard deviation (boy, did that sound 100% geeky). The range of one-year returns has suddenly gone haywire, with bond ETFs trading more wildly than at any time during the past 20 years, except of course for the 2008 Global Financial Crisis, which is easily seen on the left side of the chart.
I see this as an invitation to look at bonds as, shall we say, more equity like in terms of return/risk tradeoff than at any time in my career. That's because investors are obsessed with:
- Fed policy, including every word spoken by Chairman Powell and his crew
- If inflation will re-accelerate, and when
- Whether the banking industry will spawn another crisis of confidence
- How fragile the credit bond markets are, now and into next year's massive corporate refinancing slate (lots of corporate bonds moving)
- What the long-tenured, deep inversion of the yield curve means
- Whether Europe's greater economic issues will bleed more into the US market than they have
And much more. In other words, bond markets are being shaken by a number and range of factors that we have not seen in a very long time. In fact, you could forgive many investors from even being familiar with any of this. After all, rates have been suppressed at such low levels for so many years, the high-quality bond market was reduced to little more than a short-term bond fund. But times have changed. And, I'll say it again: I'm excited.
Above is a chart of the 10-year US Treasury Bond rate going back to the start of this century. Below that is 3-year rolling returns of a Vanguard mutual fund (so as to get the longer track record), which is my proxy for returns of Treasuries in the 3-10 year maturity range, which is what that fund tends to hold. This is all just a baseline for my main point.
Rates were generally sliding or steady for the better part of the past 20 years, and that led directly to successful careers for active bond managers. As you can see in the three-year returns of the Vanguard fund, this was a blissful period for those who simply owned intermediate-term Treasuries. No credit risk, modest term risk, and satisfying interest rates. As a result, over most three-year time frames, this very basic, lightly-managed strategy often produced annual returns of 6%-10%.
Again, using AGG as a proxy for today's bond market, I see an asset class that finally pays me to be there, and is volatile enough to allow me to try to use my usual tactical tools (macro trends, technical analysis, valuation and other quantitative evaluation measures) to try to get somewhere that equity investing has struggled to do for about two years now.
Granted, AGG has about a 30% allocation to corporate bonds, and its average duration is slightly longer than the Vanguard Treasury fund I referenced earlier, so it's not the ETF I'd want at the center of my tactical bond allocation. But as it is the most common benchmark for "the bond market," I think it is useful in this analysis.
Now, rates are returning to range where they spent the first decade of the 21st Century. How stable will they be at these levels? Who cares? I don't. Because the point here is not to lock in those rates, but rather to use them as a decent base to accomplish the following:
- Earn a total return in the upper single digits over most three-year periods
- Avoid credit risk (unless you consider the debt ceiling talks to be a source of credit risk, in which case everything in investing is a "crapshoot" and we might as well bury our wealth in the backyard)
- Sidestep the nuttiest stock market I've seen in 30 years as a professional investor. By no means am I avoiding equities completely. I'm just adjusting downward my allocation to them, and my interest in continuing to get so deeply into the palace intrigue that is today's stock market.
Not our parents' equity market...and that calls for some adjustment the tactics we use
Simply put, equity prices are influenced by many new factors that render much of what worked in the past less potent. When equity investing comes down to guessing which way a stock will react to corporate earnings, at the risk of being 10%-15% wrong, or crowding into overpriced FAANG stocks because it's a self-fulfilling prophesy at a level we have not seen since the Dot-Com Bubble, I say tread lightly. That's what I've been doing since mid 2022, when I shifted more than half of my portfolio allocation to T-Bills, T-Bill ETFs and similar vehicles.
But now that rates are high enough to get paid decently for being invested in intermediate-to-long-term Treasuries, I see tactical management of the yield curve, compare it to the current state of active equity management (which is like walking in the dark) and I see a lot of what made me a tactical manager starting about 25 years ago: The opportunity to add value via low-volatility return and income, around a base investment (Treasuries) that is much more attractive to me versus the never-ending drama of the equity market.
Implications for portfolio management
First, as for AGG, I rate it a Hold, as the key point here is that the bond market, and specifically the US Treasury curve, is as intriguing an opportunity to generate multi-year total return as I've seen in my career. Any ETF that is the "core" of such a portfolio is just a placeholder to work around. The alpha will not be generated primarily from a core holding, but rather from the active moves around that core.
This may all just be a way to "live to fight another day," or a couple of years or so in this case, until the stock market comes to its senses. For that to happen, we'll need to see 15 years of ever-rising speculative activity, casino-like investment approaches, hype beyond my imagination, and all the other things that make equity investing a dangerous climate, subside. What will that take? At least a retest of S&P 500's 2022 lows around 3,600. More likely, something well south of that (think, an S&P 500 level that starts with a 2).
If history is any guide, that could take a few months, a few years, or, as we saw from the late 1990s to around 2012, more than a decade of volatile equity markets that led to a net return of about zero. That is, I'm not waiting around for the stock market to act its age again. Of course I continue to allocate to equities, but as noted in previous articles, the stock market is best "rented" rather than owned at this stage of the market cycle.
As for the weapons of choice, I'm an unabashed fan of ETFs for tactical investing. Among my likely tactical tools moving forward are ETFs that target a specific spot on the Treasury yield curve, those that cover the broader "ladder" of Treasuries (as a core investment to manage around) and especially short-term Treasury ETFs. There are tons to choose from in all of these categories, and I've profiled several and will provide updates on many in the near future.
The casualty, if there is one here, is my use of "inverse" or "bear" ETFs. By no means am I dropping them from my portfolio. I'm just being much more selective, and with T-Bill and T-Bond ETFs taking up a historically-high amount of space in the portfolio, there's a lot less space for long and inverse equity ETFs, which have been the 1-2 punch I used during all those years when buying "bonds" meant earning less in income than the fee I charged clients (I was an investment advisor for 27 years before selling my practice in 2020).
So, there's one long-time investor's take on a new but old way to pursue intermediate-term total return in a market gone wild. This will obviously not be the last time I'll cover related topics, and I'll report on which ETFs I'm using (other than my current buy-rated names) as my toolbox for actively managed bond ETF portfolios expands. In the meantime, like many investors, I look forward to the day when the stock market offers a lot of return for the risk taken, rather than the other way around, as is the case currently. Then again, I might really get hooked on this tactical Treasury thing.
For further details see:
It's Springtime For Active Bond Investors: Finally, A Tactical Opportunity, Including AGG