Table of Contents
What is treasury bond?
Treasury bonds are long-term debt securities issued by the U.S. government that pay a fixed rate of interest every six months until they mature. They are like loans we can give to the U.S. government. In return, they promise to pay you back with a little bit of interest every six months.
How is treasury bond affected by interest rate and inflation?
Bonds are with fixed interest rates. In a rising interest rate environment, existing bonds with fixed interest rates become less attractive compared to new bonds issued at higher rates. Therefore, bond price will decline. Vice-versa in the case of declining interest rate environment.
Bond prices are influenced not only by actual changes in interest rates but also by the market’s expectations regarding future interest rate trends.
Interest rate is utilized by the Federal Reserve to maintain price stability. To manage high inflation, the Federal Reserve may decide to raise interest rates, and lower them when inflation is subdued.
In conclusion, high inflation typically results in increased interest rates, which then lead to a decrease in bond prices.
How to buy treasury bonds?
Retail investors can buy treasury bond ETF (exchange traded funds). There are treasury bond ETFs with different maturity durations on the market. Here I’m going to focus on iShares 20+ Year Treasury Bond ETF (TLT).
Here is a list of treasury bond ETFs by iShares and their yield.
Treasury Bonds Product Brief (ishares.com)
How does TLT ETF work
The TLT ETF works by tracking the performance of long term U.S. Treasury Bonds. TLT operates as an ETF, pooling investors’ money to purcahse a portfolio of long-term U.S. Treasury Bonds.
TLT factsheet
TLT vs interest rates chart
The chart compares the movement of the TLT price with the Federal Reserve’s base interest rate from 2022 to February 2024. It illustrates a prominent decline in TLT price during the period of increasing interest rates.
Calculate potential gain
To calculate movement of bond price from the interest rate changes, “effective duration” information if required.
Effective duration measures how many percentage points the price of the bond will decline if the yield advances by 1 percent. According to factsheet here, as of Dec-2023, the effective duration is 17.08 years, i.e. for every 1% reduction in interest rate, potentially there could be 17% of gain.
Forex consideration for foreign investors
Foreign investors should consider the forex risk because a falling interest rate could devalue the US dollar against other currencies. This could potentially negate some profits from US treasury bonds when converting back to their home currency.
Is it a good time to buy TLT now (as of Mar-2024)
The Federal Reserve’s base rate is expected to decrease in both scenarios of the US economy achieving a soft landing or experiencing a hard landing. In fact in the case of hard landing, FED would reduce interest rate in a faster face, making long-term treasury bonds such as TLT serving as a a hedge against recession.
At this point of time, the largest risk to invest in TLT is higher than expected inflation, which forces FED to further increase the interest rate. Nonetheless, the prevailing market sentiment suggests that interest rates have peaked, indicating a potential for TLT prices to rebound. The uncertain factor is the speed of this recovery.
Let’s conservatively assume interest rate would be lower to around 4.5% in 2024, the potential gain could be in the range of 10 to 15%. If the interest rate falls back to 3% in 2 years’ time, then the capital gain cover this period could be 30 to 40% over this period. Note that forex movement is not taken into consideration here.
Although investments in storks or ETF may provide more superior returns, in my personal opinion, TLT or other long-term treasury bond ETFs are still attractive considering the risk-reward profile. In the prevailing environment, they offer a high probability of a decent return with a comparatively lower risks.