Investors are shunning government bonds due to concerns about rising supply and higher inflation. However, the dire state of US government finances may end up being bullish for Treasury bonds. The TLT holds US Treasuries of maturities of 20 years or more, with a weighted average maturity of around 26 years, and an effective duration of 16 years. This makes the TLT one of the riskiest bond ETFs on the market in terms of its volatility and sensitivity to interest rate expectations. However, it also has the potential to post strong capital gains if yields decline as I expect as the Fed looks to cap yields below current levels to ease Treasury funding costs. I think we are close to another yield peak and am therefore shifting my recommendation to a strong buy. As we have seen over recent years in the case of Japan, faced with a spiraling debt burden, the Bank of Japan drew a line in the sand regarding yields. Japan’s debt to GDP ratio first hit 120%, the current level in the US, back in 2002 and since then, its long-term bonds have returned over 4% annually in real terms, which highlights how bonds can perform extremely well even as debt ratios rise beyond 100% of GDP. While the US does not have the same deflationary pressures as Japan has had over this period thanks to its large external surplus, it does have the benefit of highly positive real yields. This means there is considerable room for inflation expectations to rise without driving up nominal yields should real yields decline. Note that it would not necessarily require the Fed to reinstate its bond buying program in order for real yields to fall. Even if the Fed were to hint at the possibility, it would likely trigger a stampede into long-term bonds as investors would see downside risks as capped and look to front run any eventual buying. The main risk to the TLT comes from a disorderly decline in the dollar as investors anticipate a return of quantitative easing, which causes a surge in inflation. The high share of US debt in the hands of foreign investors raises the risk of a dollar crash, should investors anticipate endless large fiscal deficits and debt monetization. We cannot rule out a situation where yields resume their rise, causing Treasury interest costs to rise and fiscal deficits to widen further in a crack-up boom scenario. However, for now, the dollar remains firmly on the front foot, which is a sign that higher yields should act as a disinflationary force rather than an inflationary one.
The Case for Strong Buy on iShares 20+ Year Treasury Bond ETF (TLT)
