GOVT: The Upside To Treasuries Exists Only If Things Get Worse


Main Thesis

The purpose of this article is to evaluate the iShares Core U.S. Treasury Bond ETF (GOVT) as an investment option at its current market price. This fund covers a popular asset class, U.S. Treasuries, and this is an area I believe investors may want to look at if they expect equities to come under pressure in the months ahead. Personally, this is an outlook I have, as I see a challenging economic environment persisting for longer than the market seems to be anticipating. With jobless claims still at high levels and economic re-openings occurring only in phases, I see a long way to go before we get back to “normal.” Despite this reality, equity prices have rallied almost back to pre-crisis levels, which makes me cautious. While my optimism for GOVT is limited due to the fund’s declining income stream and high price, I believe it could serve as a valid hedge going forward.


First, a little about GOVT. The fund “seeks to track the investment results of an index composed of U.S. Treasury bonds.” It offers investors exposure to U.S. Treasury bonds across a range of maturities, between one and thirty years. GOVT currently trades at $28.11/share and pays a monthly distribution, with a yield of 1.63%. I covered GOVT for the first time a few months ago, when I placed a neutral rating on the fund. Simply, I did not see much upside potential, and that call turned out to be quite accurate in the short term:


Source: Seeking Alpha

As the equity markets have continued to rally, much to my surprise, I thought it was an opportune time to take another look at GOVT to see if I should alter my rating from here. After review, I continue to believe a neutral rating is most appropriate, but believe there is a buy case to be made, if investors are anticipating an equity correction, as I am.

Why Should Investors Consider Treasuries?

To begin, I want to discuss the primary reason why investors would want to consider treasuries on a broad level. Of course, U.S. treasuries provide a stable income stream, which should pique the interest of income-oriented investors. While the yield is relatively low, it is about as safe a yield as one can find in the market, which helps ensure constant demand to some degree.

But beyond the income stream, many investors use treasuries as a way to offset equity risk. In both the long and short term, investors may want to park cash there to earn something, even if the yield is small, in order to take risk off the table while they look for better entry points elsewhere. Essentially, treasuries can act as a hedge when other corners of the market look overvalued. It helps keep a portfolio diversified, which investors can rely on for as long or short a time period as needed. Some may want to hold treasuries up to and through retirement, while others may want to hold them only until prices in other sectors decline. Either way, treasuries serve as a useful hedge.

With that in mind, let us consider why this is the case, and why GOVT may be an option for turbulent times. The reason why investors flock to treasuries during volatile market environments is because, historically, U.S. treasuries have a negative correlation with U.S. equities. What this means is, as equities move up or down, treasuries often move in the other direction. And the negative correlation is quite substantial, especially over the past two decades, as the chart below illustrates:


Source: BlackRock

What I want to emphasize is that treasuries, with their solid credit rating and defensive nature, will often perform their best when equities are moving lower, and vice versa. Therefore, for an investor who is anticipating equities to move lower, which is a reasonable outlook considering where the major indices are sitting right now, it may be an opportune time to start a position in GOVT.

Why Consider Treasuries Now?

My previous paragraph discussed the primary reasons for buying in to treasuries in general, which includes diversification, equity hedging, and income generation. However, these points are generally true all the time, so I want to focus next on why investors may want to currently consider GOVT, beyond those general points.

This is an important analysis to undergo right now, because while equity markets are sitting at high levels, treasuries are also sitting with historically high prices. As the Covid-19 pandemic creates uncertainty and interest rates remain low, treasuries have rallied, so buying-in now may seem a bit late in the cycle. Simply, this is not an unknown strategy, and investors may see little upside to be had. This is a fair point, and a quick look at yields shows us there does appear to be limited opportunity for gains. For example, the 30-year yield has reached the bottom-end of its normal range for 2020, as shown below:


Source: Bloomberg

This in and of itself is a worrying sign. It shows me that, despite the equity rally, there is plenty of fear in the market at the moment. Demand for 30-year treasuries is high, which means investors are seeking safe havens. While the yield has hit lower levels this year in March, it was very brief, before the Fed and Congress stepped in with unprecedented stimulus measures. Therefore, the yield suggests treasuries are already priced for a difficult environment.

My point here is that treasuries are not very attractively priced for new buys, unless things really deteriorate. What I mean is, the market seems to be pricing in some fear already, so if economic numbers come in better than expected, a sell-off of treasuries will likely occur. This presents some risk, and exposes investors to plenty of downside potential. This is a key reason for my “neutral” rating, as opposed to “bullish,” even though I do expect treasuries to see gains in the months ahead. This outlook is tempered by the fact that there is more downside in this sector than usual, so investors need to consider that carefully before starting a position.

With that in mind, I do see justification for an equity correction, which would encourage continued Fed buying, and retail investor buying, of treasuries, even with yields where they are. If that happens, prices could indeed move higher, and re-test the March highs. This belief stems from the fact that I personally see the market as under-estimating the challenging economic climate facing America, and the world. Yes, things have gotten better, but they are nowhere near “good”. What I mean by this is that economic readings are coming in showing strong month over month gains, but the last few months were some of the worst in modern history. If we expand our horizon out to a year over year comparison, we see that economic readings are quite weak, even if they have improved a bit in the short term.

To illustrate these points, I will give a few examples, of which there are many to choose from. One graph illustrating how difficult the corporate environment is right now is the rate of high yield bond defaults, as shown below:


Source: Forbes

As you can see, defaults have picked up dramatically this year, which is certainly to be expected. But what is worrying is the sheer level of them, in terms of the number of defaults and the volume. Current levels exceed what we saw in the 2008-09 crisis, which raises a red flag, in my view.

Another great example of how “better” does not mean “good,” is illustrated by plant-use rates, or capacity utilization, which measures how much of a plant is actually in use. A low plant-use rate would suggest demand for a company’s products is low, and the company expects future demand to be low, limiting how much they are producing. It would also suggest current capital is being under-utilized, leaving little incentive for expansion in the near term. If that is occurring on a broad scale, it would limit future economic activity.

Unfortunately, this is exactly what is happening. While plant-use rates saw a sharp rebound last month off their record low, they are still well below pre-pandemic figures, as shown in the following graph:


Source: Bloomberg

These are just two examples, there are many more I could choose from, such as unemployment claim numbers, retail sales, or consumer loan delinquencies, all of which have seen improvements that encouraged investors, but are still registering at a poor level when we consider a longer time horizon. For me, this suggests the market is a bit blinded by how bad conditions on the ground really are, and are placing too much emphasis on short-term improvement. If reality starts to sink in, equities may be in for a turbulent Q3, and that justifies continued long exposure to treasures through GOVT.

GOVT’s Income Continues To Decline

My final point goes back to GOVT specifically, and considers the fund’s income stream. As I noted in my last review, GOVT’s distributions have been under pressure. This makes logical sense, as the Fed has pushed the benchmark interest rate lower. However, the implication is the actual income stream investors receive is lower, which is a negative development. This again points back to why I am more “neutral” on this fund. While GOVT may see a bump if volatility comes back to the equity market, there is a limit to how much investors will be willing to pay for a low, and declining, dividend stream.

To see why, let us consider the recent trend for GOVT’s distribution. Back in May, I noted how the fund had seen a drop of almost 17% in year-over-year distributions. Unfortunately, the June and July payments reflect an even larger drop in income, as shown in the chart below:

Feb – May 2019 Distributions Feb – May 2020 Distributions YOY Change
$.18/share $.15/share (16.6%)
Jun-July 2019 Distributions Jun-July 2020 Distributions
$.087/share $.067/share (23.0%)

Source: iShares

My takeaway here is this offers further support for my modest outlook. GOVT already has a relatively low yield, and this trend of lower distributions is unlikely to reverse any time soon. While I see a chance for investors to profit from GOVT if equity markets take a breather, the low yield will prevent future gains from being too impressive.

Bottom Line

GOVT has seen a flat return from my last review, but I expect it to move modestly higher going into the fall. The equity market looks too richly valued to me, and if equities move lower like I expect, there is a good chance GOVT will see some gains. That said, I wouldn’t expect more than a small positive return, given that GOVT is already at a 52-week high and its income stream is on the decline. But it does provide a way for investors to limit their equity exposure and earn some level of return, which I personally feel is a wise move at the moment. Therefore, my outlook on GOVT is more optimistic than it was in May, and I recommend investors give the fund consideration at this time.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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