TLT: Why Surging U.S. Debt Levels Are Bullish For Bonds (NASDAQ:TLT) (2024)

I am upgrading my recommendation on the iShares 20+ Year Treasury Bond ETF (NASDAQ:TLT) from a buy to a strong buy, following the latest selloff which has seen the yield on the ETF rise back to 4.8%. While investors are shunning government bonds amid growing concerns over rising supply and higher inflation, the dire state of US government finances may well turn out to be bullish for Treasury bonds. The thesis is simple; at current interest rates, the Treasury will risk losing control of the bond market and the Fed will be forced to undertake quantitative easing to keep yields low. As we have seen in Japan over the past decade, inflation concerns take a back seat when fiscal sustainability comes into question. While renewed QE would likely undermine real returns, declining real yields are likely to more than offset any rise in inflation resulting in strong real total returns over the coming years.

The TLT ETF

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, as evidenced by the fact that it remains almost 50% below its 2020 peak when long-term yields bottomed. 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 last wrote about the TLT in January, arguing that while the long-term outlook was strong, continued equity gains posed a risk to rate cut expectations and therefore the TLT. Since then, the yield has risen by around 60bps, and if we break down the yield into the yield on inflation-linked bonds (TIPS) and long-term breakeven inflation expectations, we can see that around 50bps of this rise has come from rising real yields. 30-year real yields now sit at 2.4%, just shy of their 2023 highs. I think we are close to another yield peak and am therefore shifting my recommendation to a strong buy.

Expect The Fed To Follow The Bank Of Japan's Playbook

With no end in sight to US fiscal deficits and interest costs rising exponentially relative to tax receipts, something has to give. 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. The chart below shows the correlations between 30-year UST yields and 30-year TIPS yields, as well as the correlation between 30-year UST yields and 30-year breakeven inflation expectations. Real yields have been a far bigger driver of nominal yields than have inflation expectations, suggesting that any move lower in real yields would drive positive returns in the TLT, even if inflation expectations were to rise.

This is the benefit of long duration bonds, which have the potential to post strong capital gains even during rising inflation if real yields fall, which is highly likely. 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 Dollar Is A Key Risk

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.

Summary

Bonds are under pressure in part due to fears of sustained fiscal deficits, rising bond issuance, and spiraling Treasury interest costs, but the recent yield increases have been largely driven by rising real yields rather than inflation expectations. As we have seen in Japan over recent years, the Fed will come under pressure to ease borrowing costs to prevent an exponential rise in interest payments, which should drive real yields significantly lower. While inflation pressure is also likely to rise, the TLT should still perform well as nominal yields fall given its high duration.

Stuart Allsopp