TLT, ZROZ: Duration is a double-edged sword (NASDAQ: TLT)
Yesterday was a memorable day.
The Nasdaq-100 index lost more than 5%, a rare day since the tech bubble burst in the early 2000s.
Additionally, for the first time since March 2020, not a only component of the 102-member index ended the day in the green.
2022 is a year for the history books, but not because of the technological explosion rather thanks to what is happening in the bond market.
Not only is the Bloomberg Global Aggregate Index down nearly 17% this year (on a total return basis), it’s almost as bad as the S&P 500 (down about 17.5% since inception of the year).
When was the last time bonds lost as much as stocks when the latter were down double digits? Never before.
The 13.5% drop in the US Aggregate bond index is the worst drop in (at least) the last 50 years.
Even during the 1980s, when inflation was higher than it is today (and fed funds were much higher than it is today), bonds didn’t suffer as big a drop as they did this year.
Duration is key
Let me take you back to something we wrote on January 24, 2020, even before COVID became a major global issue:
What should be absolutely clear to anyone holding medium duration bonds right now is that you’re sticking with assets that at best will generate very little gain, and in the worst case, they would look as bad as a major stock correction (SPY, DIA, QQQ, IWM) looks!
Here are the total returns of various US Treasury bond ETFs since their peak in early December 2021:
As you can see, the longer the duration, the greater the drop.
- Short-duration ETFs* managed to stay quite close (= up to 5% below) to the flatline.
- Mid-duration ETFs** lost around 10% to 15%, in line with the benchmark iShares US Treasury Bond ETF (GOVT) loss of around 13%.
- Long-duration ETFs*** have lost at least a quarter of their value, but sometimes double!
*SPDR® Blmbg 1-3 Mth T-Bill ETF (BIL), iShares Short Treasury Bond ETF (SHV), iShares 1-3 Year Treasury Bond ETF (SHY)
** iShares TIPS Bond ETF (TIP), iShares 3-7 Year Treasury Bond ETF (IEI), iShares 7-10 Year Treasury Bond ETF (IEF)
*** iShares 10-20 Year Treasury Bond ETF (TLH), iShares 20+ Year Treasury Bond ETF (NASDAQ:NASDAQ: TLT), PIMCO 25+ Year Zero Coupon US Trs ETF (NYSEARC:NYSEARCA:ZROZ)
Longest/Highest Duration = Strongest/Strongest Reaction
To better understand the duration effect, let’s compare the longest US Treasury bond ETFs (TLT, ZROZ) to the shortest (BIL, SHV).
Looking at the graph below (extended to the creation date of ZROZ), we can draw various conclusions:
- Time = Money. A longer duration provides better total returns over time.
- Tenor = Volatility. The longer the duration – the greater the volatility.
- Higher yields are harmful, just as lower yields are helpful.
- The longer the duration, the greater the levy.
- Next time we warn about duration, hear us out!
However, one thing should also be clear: long-duration ETFs will always be the best or the worst holdings, depending on the monetary policy (hence, direction of nominal yields) we live in.
- Fed dovish >>> Monetary policy easing >>> Lower yields >>> Long-duration ETFs flourish.
- Hawkish Fed >>> Monetary policy tightening >>> Higher yields >>> Long-duration ETFs are fading.
The Power (Powell) of Love (duration)
First, let’s compare the two long-duration ETFs we focus on in this article: TLT and ZROZ.
The 3 most important things we would like to draw your attention to are:
- The smaller the coupon, the smaller the difference between the duration and the average maturity.
- The shorter the duration – the lower the volatility (standard deviation)
- It’s not the average time to maturity that you should focus on, but the duration.
|Effective duration||17.86 years old||26.36 years old|
|Number of participations||33||23|
|30 Day SEC Yield||3.47%||2.92%|
|Standard deviation (3 years)||13.37%||18.86%|
|Weighted average coupon||2.41%||0.01%|
|Average yield to maturity||3.68%||3.54%|
|Weighted average maturity||25.71 years old||27.30 years|
|Gross expense ratio||0.15%||0.15%|
Note that both ETFs offer a similar profile except for duration (TLT is significantly shorter than ZROZ) and coupon (TLT is significantly higher than ZROZ). The fact is that one (coupon) affects the other (duration), so essentially duration (+ coupon) is the main difference between the two ETFs.
How important is it?
As you can see, there is no (or almost no) time when ZROZ’s drawdown was lower than TLT’s.
By definition, the longer duration ETF will always suffer greater losses.
On the other hand, the longer duration ETF will always offer higher returns in times of easing (monetary policy) and lower yields.
The fact is that you have to be very careful in choosing the right instrument at the right time.
Easier said than done, of course, but when it comes to bonds, it’s almost a scientific task compared to a sentiment-based decision when it comes to stocks.
Yields vs Yield Curve
Yesterday, before the inflation figures were released, we wrote an article in which we explained that investors must differentiate between (nominal) yields and the (inversion) yield curve.
Yields rise or fall mainly due to inflation (expectations) and monetary policy (tightening/easing). The economy may be bad, but if there is high inflation and/or the Fed is hawkish – yields will rise, catching up to the 2 P’s: Price and Powell.
The yield curve, on the other hand, is a reflection of the economy. The worse the economy, the less steep the curve. And in the event of a possible imminent recession, the yield curve tends to invert.
We ended this article with the following words:
We strongly suggest investors place more trust in bonds (credit markets) than stocks (stock markets). The latter make more noise, but the former lead the way.
Don’t ask where yields “should be” based on the economy, but rather where the economy is (probably) heading based on yields, or even better: the yield curve.
Guess what happened after the higher than expected inflation figures?
1) Yields have increased
This applies to both nominal yields and real yields.
The 2-year US Treasury yield hit its highest level in 15 years.
The real yield on the 10-year US Treasury is rapidly approaching its highest level in 11 years.
And as yields soared, the yield curve inverted more than it did before the data.
The 10-2 year US Treasury yield spread fell 12 basis points, reaching 33 basis points below the reversal line.
The 10-year and 3-month US Treasury yield spread fell 6 basis points, now just 14 basis points from the reversal as well.
Slowly but surely, investors are anticipating a very hawkish (and determined) Fed as well as a deteriorating economy and possible recession.
At the moment, according to the market, a rate hike of 75 basis points at the next FOMC decision (a week from today) is guaranteed (certainly 100%) with a probability of 1/ 3 for a full one percentage point increase.
Personally, I doubt Powell & Co. will rise 1%, to avoid panic. Nevertheless, when the probability reaches 70% (or more), the Fed tends to respect market expectations, so if in a week the probability of a 100 basis point hike is >= 70% – we could be entitled the biggest increase of all time. since the Fed started using Fed Funds as its main tool (in the early 1990s).
Remember: duration is key, and when choosing a bond ETF, duration should be a primary consideration in finding the most appropriate instrument for existing (and expected) financial conditions.