With short-term US bonds yielding significantly more than long-term US bond yields, many bond investors understandably see the short-end of the curve as the better bet. However, long-term bonds have much greater upside in the event of a fall in yields and inverted yield curves tend to be a bullish factor for future bond returns rather than a bearish one. The Vanguard Extended Duration Treasury ETF (NYSEARCA:EDV) offers one of the best options for investors looking to lock in relatively high bond yields in anticipation of a fall in inflation and a downward reversal in interest rates.
The EDV ETF
EDV holds a portfolio of 20- to 30-year Treasury STRIPS, which represents a single coupon or principal payment on a US Treasury security that has been stripped into separately tradable components. These securities promise a single payment upon maturity in the next 20-30 years, without any interim coupon payments. As a result of the lack of coupon payments, the fund has an extremely high average duration relative to most bond market ETFs, at 24.2 years, and effective maturity of 24.7 years. The long maturity and duration of the EDV means it is highly sensitive to changes in interest rate expectations, and extremely volatile for a bond fund. The current yield to maturity is around 4.2%, which is significantly above long-term inflation expectations.
The Bond Market Is Right
While an inverted yield curve makes long-term bonds relatively unattractive, previous periods of inversion have actually led to above average returns for long-term bonds. As shown below, on each occasion since 1988, 30-year UST yields have fallen when measured from the beginning of the curve inversion to the end of it. Furthermore, even investors who bought long-term bonds at the start of the steep curve inversion seen from the late-1970s to the early-1980s saw incredibly strong long-term nominal and real returns.
This is why many investors often say the ‘bond market is always right’. Curve inversion tends to be resolved in a sharp decline in near-term rates, which actually also drags long-term yields further lower. This is not a coincidence, but a reaction to the contractionary economic effect that rising short-term bond yields have. Rate hikes help induce a decline in the demand for borrowing and a rise in the demand for cash, which can be reinforced if the rate hikes result in a recession. As a result, inflationary pressures fall and investors anticipate further rate cuts, driving down long-term bond yields.
A Return To Average ‘Normal’ Yields Could See The EDV Rise 60%
We would not actually need to see a sharp fall in inflation expectations in order for long-term yields to decline and the EDV to rise significantly. 30-year breakeven inflation expectations sit at 2.4% meaning that real returns on the EDV should be expected to average 1.7%. This compares to a post-War average real yield of around 2.3%.
However, as explained in ‘LTPZ: Real Yields May Need To Move Back Below Zero To Prevent A Fiscal Meltdown‘, real GDP growth is likely to come in around zero compared to the long-term average of 3.1%. This means that real bond yields are currently 1.7% higher than the real GDP growth outlook, compared to a long-term average of 0.8% below. 30-year real yields would therefore have to fall by 2.5pp in order for them to be in line with the long-term average. With a duration of 24.2 years, a 2.5pp decline in the yield on the EDV would result in a gain of 60% for the ETF.