GOVZ: Zero Rate Cuts And More Pain For Treasury Bonds (BATS:GOVZ)

The ability to change your mind with the incoming data is one of the best tools an investor has. It is also the most difficult to do consistently. We will look at our recent call on iShares 25+ Year Treasury STRIPS Bond ETF (BATS:GOVZ) and see if the trade has played out or whether the new data suggests a different approach is required.

A Brief Primer On The Fund

GOVZ is one of the more popular funds for those who like to eat bond duration for breakfast. While the fund is not really large, the $200 million odd in assets within it are not chump change either. The fund provides investors exposure to US Treasury STRIPS, with at least 25 years to maturity. STRIPS here actually stands for “Separate Trading of Registered Interest and Principal of Securities”. These are created by separating coupon payments and principal repayment and selling them to investors as zero-coupon bonds. The duration risk for GOVZ and similar other funds is off the charts. While most other bond funds have periodic interest payments, GOVZ is reliant on that large pot of gold at the end of a 25-year rainbow. Geek math will tell you that since you are not getting anything in the interim, your interest rate/duration risk is very high. Of course, the opportunist will argue that the interest rate/duration reward is also very high if we get a lot of rate cuts.

Our Previous Stance

Some of our article titles are subtle and some are not. This one fell in the latter category.

We would encourage investors to read that one first as we are building off the key themes from there, but our take-home message was as follows.

With $9 trillion in refinancing plus budget deficit needs in 2024, investors might be walking into a rough setup. Currently, there is just no upside to locking in long duration. Biding time by holding TBIL or iShares 0-3 Month Treasury Bond ETF (SGOV) makes sense for now for the Treasury portion of your bond portfolio.

This worked out about as perfectly as we could envision.

GOVZ underperformed the S&P 500 by 22% or at over an 80% annualized rate. This is one of the worst performances for long bonds relative to the broader equity markets in a long time. Equally importantly, our choice SGOV took GOVZ out into the back alley and beat it mercilessly.

Outlook Update

One of our key themes in late 2023 was that the market was hallucinating about 6 rate cuts. In the absence of those, you would see pain in long bonds as well. You can see that rate cut expectations peaked around the time of our last article and this chart below, which runs till March 15, shows 3 potential rate cuts.

Unfortunately for bond bulls, it has gotten worse and now the first rate cut is projected for September 2024. The odds of a rate cut that close to the election appear to be extremely low for us and this likely keeps the pain setting on longer-dated bonds. Some Federal Reserve board members have been voicing concerns that the “Powell Pivot” was premature.

As we were writing this, the Wall Street Journal dropped this nugget on us.

What about the bond model we have been using in conjunction with the data to keep us on the right side of the trend? That model looks a bit better for longer-dated bonds, but we are not quite there yet.

This one only puts 10-year Treasuries on a “buy” when they yield more than the weighted average of 3 components.

1) 3-Month T-Bills (Weighted at 50%).

2) 12-month Core CPI (Weighted at 25%).

3) 12 Nominal GDP (Weighted at 25%).

The biggest component here is the 3 month Treasury Bills. This is the crux of the long thesis for T-Bills versus longer-term bonds.

Why lock in GOVZ at 4.53% yield to maturity when you can get 5.40% on the risk-free side with no duration?

Updating our other numbers today, we get

1) 3 Month T-Bills at 5.40% (slightly lower than last time).

3) Trailing 12-Month Core CPI at 3.8% (lower than last time).

3) Trailing 12-Month Nominal GDP at 5.86% (lower than last time with one quarter of roll).

The weighted average of the three is at 5.1% and 10-Year Bond yields are at 4.4%. GOVZ has a yield to maturity of 4.53%. But the differential has decreased and bonds are less problematic on a relative basis. If we see more slowdown in the economy, and 10-year yields rise further, they will become more attractive on a relative basis. At present this model keeps them on a Sell, but since the differential is lower we are “upgrading” GOVZ from “Strong Sell” to just a “Sell”. Of course, investors seeking some certainty of interest rate action can “lock-in” by buying some fixed income. At present, 1 year CDs appear to be a good choice. Here, you can get better than the 3-month Treasury bill rate and far better than the 1-year Treasury rate.

GOVZ: Zero Rate Cuts And More Pain For Treasury Bonds (BATS:GOVZ)