The objective of the Vanguard Extended Duration Treasury ETF (NYSEARCA:EDV) is to track the performance of an index composed of long-duration zero-coupon US Treasury securities. Now those who have invested in EDV in The first signs of market turmoil in November 2021 when the tech bubble started to burst, or later in February when it became clearer that inflation would not be transitory, got the timing wrong as the ETF suffered from a relentless decline. Breaking with the decline, as seen in the latter part of the blue chart below, there appears to be a trend reversal.
With some uncertainty surrounding the 50 basis point interest rate hike in early May, there is now more reason to believe that the Vanguard ETF will continue to rise as I will discuss in this thesis. I base my arguments on market signals, uncertainties about the economy, and central bank actions.
Signals based on treasury bills
First, after hitting its highest level since 2018 last Thursday, the yield on the benchmark 10-year Treasury fell to 2.84%, as seen in the blue chart below.
Now, rates normally fall when investors buy bonds in risk aversion against stock market volatility, as was the case last week, with the S&P 500 losing 3.8% from Monday to Thursday.
Second, on March 31, this time as shown by the orange chart crossing over the blue chart, the 2-year and 10-year Treasury yields reversed. This was a significant event as it did not happen until 2019. Analysts normally view this as a warning signal of an impending recession as short-term (two-year) borrowing costs are higher than in the long term (10 years) . This is not normal because when you lend money to someone, in this case to the US government over a longer period of time, you take on more risk and expect to be rewarded accordingly, through a rate of higher interest.
Third, there was an acceleration in the rate at which the two-year Treasury yield appreciated, as seen in the relatively steeper slope of the orange chart just before the reversal. According to analysts at Deutsche Bank (DB), this phenomenon last occurred in 2009. However, this year reminds us of the great financial crisis that occurred from 2007 to 2008.
Without going into the details of the functioning of the debt market or the monetary policy of central banks, these signals are especially important in the context where the Federal Reserve is raising its key rate from mid-March, thus breaking with the policy of monetary support that had been in effect since the COVID-19 pandemic from April 2020.
This is therefore a major change and implies that the era of cheap money which allowed listed companies to raise funds quickly through the sale of shares could be coming to an end, as well as their ability to borrow money at low interest rates.
Troubled Times Ahead
This is just the beginning as there is more to come with more rate hikes expected this year, all in a short period of time. By comparison, there had been no hike since 2018. Moreover, under normal circumstances, the normalization of monetary policy or the abandonment of quantitative easing (“QE”) in place for ten years takes the form of a gradual process carried out taking into account economic indicators such as labor participation, industrial production, cost of living, etc.
However, this time it will be done quite abruptly. To make matters worse, there seems to be less consensus between central bankers and mainstream economists as to what constitutes the so-called “neutral interest rate”. Add to these concerns high inflation for 40 years, you may have the ingredients for a recession.
On the other hand, unlike 2008-2009, financial institutions are strong and people have money in their savings accounts, but supply chain problems persist and the Russian-Ukrainian conflict seems to have lifted the commodity price ceiling. Additionally, Federal Reserve Chairman Jerome Powell has repeatedly stated that he believes the U.S. economy is strong enough to withstand rate hikes, but, after his “transitional inflation” rhetoric has not materialized, people lose confidence.
So, with CPI (consumer price index) readings still uncomfortably high, it could prove difficult for the Fed to stage a soft landing for the economy. Some are even anticipating a mild recession, which may ultimately lead to a market slowdown as investors panic. In this case, as shown in the deep blue chart below, EDV can act as a hedge against high volatility as it did in March 2020. At that time, the S&P 500 and SPDR Portfolio S&P 500 Value ETF (SPYV) plunged more than 30%, as seen in the orange and pale blue charts respectively.
Thinking out loud, no two market downturns are alike and some investors tend to opt for value stocks that pay high dividend yields so that they can continue to harvest cash in case economic difficulties arise. would persist. In this regard, my objective is not to offer EDV as an alternative to equities, but rather for the sake of preserving capital as part of a diversified portfolio. Additionally, the ETF pays quarterly dividends at the rate of 3.27% (30-day SEC yield).
Browsing through the ETF industry, I came across another peer that holds long-term Treasury bonds, namely the iShares 20+ Year Treasury Bond (TLT) ETF. It has significantly more assets under management compared to EDV. However, I prefer the Vanguard ETF because it is much cheaper. After issuers recently reduced fees, it is available at an expense ratio of just 0.06%.
That said, I could be wrong in my prediction and there may not be a recession, in case inflationary pressures start to ease and the Covid situation in China improves. There could also be a truce between Russia and Ukraine resulting in lower oil prices. Additionally, many seasoned bondholders have moved out of fixed income assets from their portfolios after the sell-off that has deepened since November, as the introductory chart shows. Many may not be willing to invest in this asset class again.
Nevertheless, even if there is an improvement in external economic conditions, the current volatility should persist as the Federal Reserve is making relatively abrupt changes, and holding long-term US Treasuries as part of your portfolio is relevant in order to preserve capital in the face of an increasing degree of uncertainty. Additionally, with its quarterly distributions and upside potential, the Vanguard ETF not only acts as a hedge, but can also reward investors with high returns.
Finally, I made the case for investing in EDV given three signals based on Treasury yields, macroeconomic uncertainties, and doubts about the Fed’s ability to pull the economy out of inflation slowly. That said, as far as I can remember in my thirty years of investing experience, whenever there has been extreme market volatility, it has resulted in a flight into assets like the US dollar, gold or long-term treasury bills for capital preservation purposes. This time around should be no different, and learning from the March 2020 crash when it rose over 30%, EDV could easily rally back to the $130 level.