TLT and the 20-Year Treasury Yield Gamble

The 20-year Treasury yield crosses 5.25% as TLT investors bet rates will fall.

Do you expect 5% inflation for the next 20 years? If not, you might be a TLT investor. 

The 20-year Treasury yield climbed to another historic high Wednesday, reaching 5.26% in midday trading. This yield compares to just under 1.0%, where it stood in July of 2020.  

Considering that bond prices move in the opposite direction of rates, and inflation doesn’t seem to be coming down any time soon, why are investors buying exchange-traded funds like the iShares 20+ Year Treasury Bond ETF (TLT)?

TLT Inflows Grow as 20-Year Treasury Yield Climbs

Put another way, the inverse relationship of yield and price has pushed TLT down 17% this year and the 20-year Treasury ETF has fallen more than 50% in price since its peak in 2020. Despite these negative returns, TLT has attracted huge inflows of $17 billion this year. 

One explanation for the attraction to TLT even as yields rise and prices fall is that buyers don’t believe the 5%+ yield on the 20-year Treasury bond is forecasting future inflation accurately. Today’s yields reflect market expectations of higher-for-longer inflation.  

If TLT investors are correct, yields will fall back down, and they will be rewarded with potentially significant price gains. If not, and yields remain high, or even go higher, prices may have further to fall. 

TLT and the 20-Year Treasury Yield Gamble 

Buying long positions on TLT is essentially a bet that inflation may be nearing a cyclical peak and that yields will come back down as the economy begins to cool. It’s not likely that TLT investors are buying the fund for its yields as they could get similar yields on shorter-term bond ETFs without taking the price risk. 

If the 20-year Treasury yield is near its peak, how might TLT investors benefit?  

If inflation trends downward in the coming months, TLT investors could expect up to double-digit gains, depending on how far inflation falls. This is because inflation and interest rates are closely related and the longer the bond maturity, the greater the interest-rate sensitivity. Thus, long term bond ETFs would appreciate more than short-term bond funds in this environment. 

Bond Duration and TLT’s Potential Rise in Price 

An investor can estimate a potential price increase on a bond fund by multiplying the fund’s average duration by the expected decline in interest rates. Not to be confused with maturity, duration is a measure of how many years it takes for an investor to be repaid a bond’s price and total cash flows. Thus, investors can use duration to measure a fund’s price sensitivity to changes in interest rates. 

Generally, for every 1% change in interest rates, a bond's price will change approximately 1% in the opposite direction for every year of duration. This is why long bond ETFs like TLT can see stock-like returns in a falling rate environment. 

The TLT portfolio’s effective duration is 16.5 years. So, if interest rates fall by 1.0%, TLT’s price could rise by 16.5%. For reference, the long-term average for inflation is about 3.2%. The 20-year Treasury yield is approximately 5.2%. Given a severe recession, TLT investors are looking for large potential gains. This makes TLT a recession hedge. 

While higher-for-longer inflation and rates still present significant risk for TLT and other long bond ETFs, investors are betting that prices may be close to a bottom and the upside potential may far exceed the downside risk going forward.