GOVT – A Treasuries ETF With Intermediate Duration (BATS:GOVT)

Thesis

The iShares Core U.S. Treasury Bond ETF (GOVT) is an exchange traded fund offering an investor exposure to an index composed exclusively of U.S. Treasury bonds, namely the ICE U.S. Treasury Core Bond Index. The securities composing the index are fixed rate only and they exclude STRIPS, inflation-linked bonds, floating rate notes and any government agency debt. Eligible securities have a maturity ranging from one year to thirty years. The composition of the index is rebalanced at each month end. The fund currently has a weighted average maturity of 8.26 years and a duration of 6.77 years. There are 120 securities composing GOVT with a current 30-day SEC yield of 1.66%. The fund is on the large size with a $16 billion AUM.

GOVT is a cornerstone of portfolio construction, similar to other long US Treasuries funds and represents for many investors a large allocation of the 40% dedicated to fixed income securities. It is supposed to insulate portfolios in risk-off scenarios when the equity market sells off. However, a savvy investor with an active management style should recognize that in a monetary tightening environment the 40% fixed income bond portfolio should be tilted to short-duration instruments rather than GOVT.

With an accelerating inflation picture and investment banks now expecting nine rate increases, the risks are tilted to the downside for the first half of the year. We are witnessing a violent rates re-pricing and we are not going to get a clearer picture of how far the Fed will go until later in the year when Fed funds will be higher and economic indicators are going to paint a picture of the effectiveness of the Fed hikes. We do not believe the current curve flattening is predicting a recession and we are in the camp that believes that, as the market digests a string of 25bps increases and the economy continues its robust performance, we are going to witness a normalization of the curve steepness and longer rates will move higher.

We are targeting an approximate further -4% performance in the first half of the year for GOVT as the duration equivalent risk-free rate continues to rise while the second half of the year will see a slight retracement in total return as the dividend yield covers some of the shortfall, similarly to what we witnessed in 2018. We rate GOVT as a Sell with a retail investor best suited to divest all holdings in the ETF and revisit in the second half of the year when the downwards move in price from rates would be mostly over and the fund would generate a higher overall yield.

Holdings

All the fund holdings are US Treasury securities and thus are AAA rated posing no credit risk:

The fund currently holds 120 securities that have a weighted average 30-day SEC yield of 1.66%:

More importantly, the fund currently has a weighted average maturity of 8.26 years and a duration of 6.77 years. This characteristic puts the ETF in the intermediate duration bucket as per the Vanguard bond table:

If we look at the duration equivalent risk-free rate, we can see that seven-year Treasuries just hit the 2% mark:

Given the rampant inflation picture and a hawkish Fed, we feel we are going to see a similar move in 7-year rates as in 2018 when the yield went from 2% to 3% throughout the year. We have already seen a violent repricing of yields in the beginning of this year even as the Fed has not moved on Fed funds yet, so we are penciling in a 2.75% target for end of year 2022 7-year rates. That type of move, given our duration matrix, would imply a 4-5% downward adjustment in the portfolio price given its duration.

Performance

In 2018, when the 7-year yield moved from the 2% threshold to 3%, we saw a -4% downward move in price:

We are not certain regarding the duration profile of the fund at the time, but assuming a similar 6-8 years range as today’s fund composition gives us a good feel for what to expect in 2022.

We can notice though that although the price component suffers a decline from the increase in yield given the duration the fund runs, from a total return perspective, the ETF recoups its losses through its yield, and more importantly through an increasing yield:

We expect a similar performance in 2022, with the first half of the year witnessing a downwards adjustment in NAV and price given the rising yields while the second half of the year will see a normalization towards a small negative in total returns as intermediate rates stabilize and the fund produces an increasing dividend yield.

Conclusion

GOVT is an ETF composed of US Treasuries. The fund has an intermediate duration profile and will continue to lose value as rates go up. 2022 has seen a violent repricing of the yield curve on the back of an accelerating inflation picture and discussions around the Fed being “behind the curve” on rate increases. With JPMorgan now expecting nine rate increases, risk-free rates are on an upward trajectory. We believe the Fed will adjust its pace as the market digests higher rates and the economy will continue to perform robustly. Utilizing 2018 as a blueprint for GOVT performance, we expect 7-year yields to move towards 2.75% with the bulk of the move occurring in the first half of 2022. We are targeting an approximate further -4% performance in the first half of the year for GOVT as the duration equivalent risk-free rate continues to rise while the second half of the year will see a slight retracement in total return. We rate GOVT as a Sell with a retail investor best suited to divest all holdings in the ETF and revisit in the second half of the year.