EDV – Moving From Sell To Hold After A 25% Fall (NYSEARCA:EDV)

Thesis

Vanguard Extended Duration Treasury ETF (NYSEARCA:EDV) is an ETF which invests its cash in long-dated Treasury securities. The fund has a very long duration of 24.4 years and has been negatively affected by the current monetary tightening cycle. Late last year we wrote an article where we detailed why we were assigning a Sell rating to EDV. Our call proved to be the correct one, with the fund being down more than -25% since our article versus our anticipated -20% move.

With a very assertive Fed that has jawboned the market in aggressively re-pricing the yield curve upwards we feel the bulk of the rates move is now behind us. The EDV performance is driven by 30-year rates and we feel most of the move for that point in the yield curve has already been realized. While there can still be scope for slippage up to 3.5% yields for the 30-year rate the aggressive 200 bps move up witnessed earlier in the year is not to be repeated. We are therefore moving from Sell to Hold on EDV, and waiting for rates stabilization later in the summer in order to assign the fund a buy signal.

Performance

EDV is down more than -25% since we assigned it a Sell rating:

As we mentioned in our original article:

With the Fed set to raise rates three times next year, buying a high duration fixed income fund is not optimal. In fact we expect EDV to lose value next year, mainly driven by its long maturity date profile. After spending almost two years at another bottom in interest rates we anticipate the inflationary pressures building in the economy are going to drive a sustained rising interest rate environment, which is going to put pressure on long dated treasury funds. We are Bearish EDV until the end of the structural tightening cycle.

[..] If we look at past performance during the past tightening cycle (2013-2014), we can see the fund having lost almost -20% during the initial stages

Our call proved to be spot on with the fund now down -25% since our article. We feel long dated bond funds such as EDV are a cornerstone of a well balanced portfolio, however they need to be actively traded in a shifting monetary cycle, namely a tightening one. Being long duration when the Fed is very active in achieving its dual mandate is not an optimal choice and has proven to be a significant money draining endeavor via EDV.

Holdings

STRIPS is an acronym for Separate Trading of Registered Interest and Principal of Securities. What this means is that historically investors looking at Treasury securities decided that only certain aspects were appealing to some of their needs (i.e. only the interest component or only the principal component) and decided to strip the original Treasury security into underlying cash-flows with their own identifiers. Basically STRIPS let investors hold and trade the individual interest and principal components of eligible Treasury notes and bonds as separate securities. As an example, a Treasury bond with 10 years remaining to maturity consists of a single principal payment, due at maturity, and 20 interest payments, one every six months over 10 years. When this note is converted to STRIPS form, each of the 20 interest payments and the principal payment becomes a separate security.

The portfolio contains only 80 bonds, but has a very long duration:

We can see from the fund fact sheet that the STRIPS composition allows the portfolio managers to create a very long dated portfolio with an approximate 25 years duration.

The fund falls in the long dated treasury bucket as quantified by Morningstar:

The portfolio is composed entirely of risk-free securities:

The driving factor for the fund is composed of rates exclusively since there is no credit risk in the underlying treasury securities.

Interest Rates

30-year rates are closing in on their 2018 highs of 3.43%:

Earlier in the decade, long-dated rates topped out at 3.93%. We think we are going to revisit the 2018 levels but not the 2013 ones. Ultimately, the move in rates is driven by the Fed and their tightening of financial conditions in order to contain inflation. We feel the market has already done this, and as Goldman Sachs illustrates, financial conditions are well underway to reach constrained levels:

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. The Fed wanted mortgage rates to go higher to cool the housing market, and they have. Once they start unwinding the MBS balance sheet holdings, mortgage rates are going to continue to be constrained.

While corporate balance sheets are healthy, and the need to place long-term debt at these higher levels is going to be moderate for the next few years, higher long-term rates are going to take a toll on new capital projects and investments. It will take a few months for higher rates to percolate down to the real economy, but in our view anything above 4% is going to take a significant toll on the economy.

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 trimming treasury shorts.

The Fed calendar and auction calendar for next week is:

Fed calendar:

• May 23: Atlanta Fed President Raphael Bostic, Kansas City Fed President Esther George

• May 24: Fed Chair Jerome Powell

• May 25: Minutes of May 3-4 FOMC meeting, Fed Vice Chair Lael Brainard

Auction calendar:

• May 23: 13- and 26-week bills

• May 24: 2-year notes

• May 25: 2-year floating rate notes, 5-year notes

• May 26: 4- and 8-week bills, 7-year notes

Conclusion

EDV is a long duration Treasury STRIP securities vehicle. The fund has been decimated by the violent upward swing in rates, with an approximate -25% performance year to date. With the bulk of the rates move now behind us and an aggressive repricing of the yield curve most of the negative price move in EDV is behind us. We are therefore moving from Sell to Hold on EDV, and waiting for rates stabilization later in the summer in order to assign the fund a buy signal.