TLT, Long-Term Bond ETFs Eclipse Stock Rally
It’s not just Black Friday, it’s a black November for long-term bond ETFs.
2023’s poster child for the long bond market, the iShares 20+ Year Treasury ETF (TLT), is not only far out of the red, but the current rally for this segment of the fixed-income market is outpacing the Magnificent 7-powered S&P 500, as measured by the SPDR S&P 500 ETF Trust (SPY).
While investors’ eyes have been on a new stock market rally, TLT is up 9.0% over the past one month, and SPY is up 8.2% during the same period.
Investors willing to take more risk in both asset classes in the month leading up to Black Friday have been rewarded even more. The highly interest-rate sensitive Pimco 25+ Year Zero Coupon US Treasury Index ETF (ZROZ) is up 15.9%, and the Technology Select Sector SPDR Fund (XLK) is up 13.0%.
The primary driving factor for higher asset prices across the spectrum is economic data providing signs of cooling inflation, which helps to bring down bond yields.
With just a little over four weeks to go in the year, investors will soon be turning their attention to the next year, where the "higher-for-longer” narrative from 2023 may evolve into a “lower-and-sooner” scenario in 2024.
How Falling Yields Support Stock and Bond Prices
Stocks and bonds both tend to react favorably to falling yields, albeit for different reasons. For example, stocks and stock ETFs often perform well when interest rates are falling due to several interrelated factors that influence both the cost of capital and investor behavior. Falling yields are generally favorable for long-term bond ETFs due to the inverse relationship between bond prices and yields.
Bonds and Falling Yields
Price appreciation: Bonds, including those held by long-term bond ETFs, have fixed coupon rates. When yields in the market decline, newly issued bonds typically come with lower coupon rates. Existing bonds with higher coupon rates become more attractive to investors, leading to increased demand. As a result, the prices of existing bonds rise, contributing to capital gains for investors holding long-term bond ETFs.
Inverse relationship: The price of a bond and its yield have an inverse relationship. When yields fall, bond prices rise, and vice versa. Long-term bonds are more sensitive to changes in interest rates, making them more responsive to falling yields.
Total return enhancement: Falling yields not only lead to capital gains from price appreciation but also contribute to the total return of long-term bond ETFs, which includes both capital gains and interest income. As bond prices rise due to falling yields, the total return of the ETF improves, potentially providing investors with attractive returns.
Portfolio reinvestment: As bonds in a long-term bond ETF portfolio mature or are sold, the proceeds can be reinvested in new bonds with lower yields. However, the higher yields on the existing bonds in the portfolio can offset the impact of lower yields on new investments. This dynamic process of reinvestment can contribute to maintaining a relatively attractive yield for the ETF.
Risk mitigation: Long-term bond ETFs are often considered as defensive investments. In times of economic uncertainty or market volatility, falling yields may indicate a flight to safety as investors seek the stability and income provided by long-term bonds. This defensive characteristic can help mitigate overall portfolio risk.
Interest rate expectations: When investors expect a prolonged period of low interest rates or a potential economic downturn, they may allocate more capital to long-term bonds, anticipating their price appreciation. This demand for long-term bonds can further support the positive performance of long-term bond ETFs in a falling yield environment.
Stocks and Falling Yields
Lower cost of borrowing (boost to corporate profits): Lower bond yields result in a lower cost of borrowing for companies. When the cost of capital decreases, companies can borrow money more affordably to finance expansion, invest in new projects and improve profitability. This can boost corporate earnings and, consequently, stock prices.
Income seeking: Because fixed-income investments such as bonds and money-market fund may offer increasingly lower yields, investors may seek competitive yields and higher returns in the equity market, driving demand for dividend-paying stocks.
Discounted cash flow, or DCF, models: Lower interest rates can increase the valuation of stocks through DCF models. As interest rates decrease, the present value of future cash flows used in valuation models increases, leading to higher stock valuations.
Investor confidence and risk appetite: Falling interest rates often signal accommodative monetary policies by central banks. This can boost investor confidence and risk appetite, encouraging investors to allocate more capital to riskier assets like stocks. Lower interest rates may create a "risk-on" environment, supporting stock market performance.
Improved consumer spending: Lower interest rates can lead to lower borrowing costs for consumers, including mortgage rates. This may stimulate consumer spending and contribute to economic growth, benefiting companies in various sectors and supporting stock prices.
Bottom Line on Falling Yields and Rising Prices
It's important to note that while falling yields benefit stock and bond ETFs in terms of capital gains and total return in the short term, investors should carefully consider interest rate trends, economic conditions and their own investment objectives. The relationship between interest rates and bond prices can be complex, and market conditions may vary. Furthermore, falling yields can be a sign of a weaker economy ahead, which could erode consumer confidence and be negative for stocks.
