IEI – Time To Buy Treasuries (NASDAQ:IEI)

Thesis

The iShares 3-7 Year Treasury Bond ETF (NASDAQ:IEI) is a vehicle that seeks to track the results of an index composed of Treasury securities with remaining maturities between 3 and 7 years (the intended benchmark is the ICE US Treasury 3-7 Year Index). The ETF currently sports a 4.68 years duration. Ultimately, a retail investor should think about IEI as the equivalent of buying a 5-year treasury bond outright, only that IEI continuously maintains a 5-year maturity profile, while the outright bond purchase experiences time decay and maturity roll-over.

In 2022, IEI has experienced its worst drawdown in the past decade, being down almost -10%. The culprit for this move has been the aggressive Fed rhetoric and monetary tightening, which has forced the market to violently reprice the yield curve upwards to almost 3% for the 5-year point. Yields for the 5-year tenor point have now touched on their decade-long highs of 3.05%, last achieved in 2018.

With the Fed rhetoric now changing to potentially a rate hike pause at the September meeting, it is becoming clearer that the market-anticipated 2.5% neutral rate is also viewed as such by the Fed. Financial conditions have been tightening, with rates higher, stocks down, and corporate bond spreads wider. The market has front-run the Fed, and we feel the move higher in spreads is almost over.

Inflationary pressures have affected consumers’ desire to spend on discretionary purchases, with retailers being the first to experience the impact to their bottom lines. Mortgage rates are at their highest levels in a decade, and the housing market is starting to cool down. We feel the Fed is going to hike by 50 bps at their June and July meetings and then pause to asses the economic impact.

With the bulk of the move higher in rates now behind us, we feel a retail investor is well served to start layering into a cornerstone of portfolio construction, namely a 5-year duration treasuries ETF. Any potential recessionary scenario in 2023 is a welcome positive factor for this ETF, with lower rates translating into a higher price for IEI. We now rate IEI a Buy, with a layered approach in mind in terms of building the ultimately desired exposure.

Holdings

From the fund annual report, we can get a very detailed breakdown of the holdings by maturity range:

When pricing a treasury fund and assessing sensitivities, it is important to understand the exact maturity profile of the underlying bonds so that we can better understand which point in the yield curve is the price driver. We can see from the above table that bonds with maturities of approximatively 5 years and more constitute over 70% of the portfolio.

The top fund holdings as presented in the annual report are:

The overall portfolio translates into a holdings-weighted average maturity of approximatively five years, and a similar duration:

There is no credit risk here, since all securities are guaranteed by the U.S. government. The fund’s performance is driven by rates, and more specifically by the market-required yield for the 5-year tenor point in the yield curve.

Performance

IEI has experienced in 2022 its largest drawdown in the past decade:

We can observe from the above chart that, over the past decade, the average drawdown in the fund was approximately -4%. Even in 2018, when 5-year rates eventually rose to levels we are seeing today, the fund did not experience such a violent drawdown. The reason behind the historic benign drawdown profiles is represented by the gradual move higher in rates. A gradual move higher allows the fund yield to compensate for the price loss from the move up in rates.

Not in 2022. This year, the aggressive Fed rhetoric saw a massive curve repricing in only a few months. The fund is down more than -6% year to date due to the rising rates environment:

Interest Rate Environment

Earlier in the decade, 5-year rates topped out at 3.05%, a level which has now been revisited:

With leading indicators stagnating and an escalation of recessionary discussions for 2023, the Fed does not have a lot of maneuvering space. The move higher in rates in our opinion is closer to being over than the market anticipates.

A higher number of market analysts now believe the bulk of the rates move higher is now behind us:

With BlackRock and Morgan Stanley in the camp of a rates normalization implied by current market levels, investors should start thinking about adding treasuries exposure to their portfolios.

We also like the front end of the curve better than the long end, since it experiences a greater downward sensitivity when the monetary policy is loosening:

We can see from the above graph how 2-year yields were very closely aligned with 10- and 30-year yields in late 2018, around 3%, but experienced the biggest downward shift as the Fed loosed monetary policies. The front end of the curve tended to come closest to the Fed Funds, although pricing on a bond ETF is also very much duration-sensitive (i.e., the longer the duration, the higher the impact to pricing for 100 bps in rates moves).

Conclusion

IEI is a treasuries ETF that offers a retail investor exposure to 5-year constant maturity treasuries. As yields have moved violently higher in 2022, the ETF has experienced its worst drawdown in the past ten years. With financial conditions tightening (rates higher, stocks down and corporate bond spreads wider), the market is already doing the Fed’s work.

We feel this tightening cycle will be no different than past historical occurrences, with a neutral rate achieved when Fed Funds reach 2.5%. 5-year rates have already touched the high achieved in 2018 and we feel the bulk of the upwards move is now behind us. Any potential recessionary scenario in 2023 is a welcome positive factor for this ETF, with lower rates translating into a higher price for IEI. We now rate it a Buy with a layered approach in mind in terms of building the ultimately desired exposure.