Long-term treasury bonds: Use cases and risks in 2022

The brutal bond bear market continues its march as the U.S. Federal Reserve (Fed) continues its campaign of aggressive interest rate hikes. In September, the Fed raised rates by another 75 basis points, sending the 10-year Treasury yield soaring to a high of 3.96% on September 27th. 

The current effective Fed Funds Rate (FFR) is set at 3.08% with an upper bound of 3.25%. However, it is worth noting that projections indicate that the Fed is likely to hike rates by another 150 basis points by 2023, targeting an FFR of 4% and above to fight inflation. 

The results have been brutal for fixed-income assets, particularly long-term Treasury bonds with higher durations. In September alone, the popular iShares 20+ year Treasury Bond ETF (TLT) is down -8.24%. Year to date, TLT is down -28.93%.

Still, with yields finally increasing and bond prices hitting 40-year lows, many investors may be considering a Treasury allocation. With fears of a recession or sharp market correction running high, the perceived safety of long-term Treasurys might appear attractive to investors seeking a hedge against equity risk. Here's what you need to know today.

Why long-term Treasurys?

Historically, long-term Treasury bonds have been excellent assets to add to a portfolio for diversification value and crash protection. Until 2022, they possessed the following qualities that made them suitable:

1. High interest rate sensitivity: Due to their high duration, long-term Treasury gained significant value from 2003 – 2021 as interest rates tended to be lower and inflation remained steady. When rates were cut to stimulate markets during the 2008 and 2020 crashes, long-term Treasurys gained substantial value. 
2. Low correlation to stocks: From 2003 to 2021, long-term Treasurys had a -0.29 correlation with the S&P 500 index. Based on modern portfolio theory, this made them an excellent asset for diversification. However, this correlation increased sharply to 0.66 in 2022. 
3. Positive expected returns: Unlike some diversifiers like commodities or VIX futures, long-term Treasurys have a positive expected return due to the coupon payments and guarantee of principal if held to maturity. 
4. Flight to quality: interest rates notwithstanding, there is strong evidence that during sharp market corrections or recessions, investors will "flee" to the perceived safety of long-term Treasurys due to their AAA credit rating.
5. Higher yield to maturity: With interest rates and yields increasing, long-term Treasurys are finally paying out more competitive yields. TLT currently has an average yield to maturity of 3.88% 

Why not long-term Treasurys?

Long-term Treasurys are not suitable for all investors, especially in ETF form, due to the following reasons:

1. High volatility: From 2003 to the present, TLT had an annualized standard deviation of 13.01%, very close to that of the S&P 500 at 14.14%.
2. Interest rate risk: TLT has an average duration of 17.68 years. All else being equal, a 1% increase in interest rates would cause TLT to lose around 17.68% in its net asset value (NAV).

In general, long-term Treasurys might be more suitable for younger investors with a high equity allocation seeking an asset to offset some of that risk. Older investors may find it more helpful to hold shorter-duration Treasurys matched to their time horizon. The high volatility of long-term Treasurys can be detrimental to those seeking stability from their fixed-income allocation. 

Because Treasury ETFs maintain a constant maturity, holding a long-term Treasury ETF like TLT over 20 years will not insulate an investor from interest rate risk. At the end of the holding period, the ETF will still have an average duration of 17.68 years. Contrast this to an individual Treasury bond that guarantees the return of principal at maturity, even if the bond's price falls in the interim. 

Long-term Treasury ETFs

Asides from TLT, there are a variety of long-term Treasury ETFs investors can buy. A great way to find them is via the Trackinsight ETF screener. Some examples include:

• Vanguard Long-Term Treasury Bond ETF (VGLT)
• SPDR Portfolio Long Term Treasury ETF (SPTL)
• Schwab Long-Term U.S. Treasury ETF (SCHQ)

Data as of October 10th, 2022.

Disclaimer: This article is limited to the dissemination of general information pertaining to investment strategies and financial planning and does not constitute an offer to issue or sell, or a solicitation of an offer to subscribe, buy, or acquire an interest in, any securities, financial instruments or other services, nor does it constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment.