Published on the Value Lab 1/16/22
The iShares 7-10 Year Treasury Bond ETF (NASDAQ:IEF) is a way to get exposure to duration now that rates, both inflation and interest, seem to be on track to peaking. However, the debt ceiling crisis is a development that investors should follow, as history tells us that scares with a defaulting US impairs fixed income values, demonstrating how much value comes with the US exorbitant privilege. At any rate, it’s likely best to hold off for the moment with fixed income, since everything is priced against the Treasury’s bps.
IEF Breakdown
IEF is just Treasury exposed but to longer duration bonds, and the effective duration of the portfolio ends up at 7.7 years. The YTM is 3.47% which is very much in line with the yield curve. Ultimately IEF stands as a minimal credit risk instrument with a decent yield that could end up being above market if the yield curve shifts down again, which could happen once the Fed decides what to do after some months of settled inflation.
Duration in general could be attractive right now. Inflation expectations and headline inflation figures are falling, and will fall further on base effects as we lap the real beginning of inflation in February. When that happens the Fed will sooner or later reduce the interest rates, and the IEF should appreciated quite meaningfully.
However, the current debt ceiling crisis is a problem.
Firstly, it is generally understood that with the government in somewhat of a shutdown, the debt ceiling needs to be raised urgently or the Treasury may not be able to pay debt sometime later this year. This happens every so often, and it is usually a moment when conservatives try put pressure on major costs like welfare and others that the narrative calls bloated, and where some limits on budget become negotiated that can sometimes affect how much money can go around for things like subsidies and other programs that are generally more supported by the liberal platform.
While the chances of default are low, investors must be aware of the potential effects if even a momentary default occurs. History tells us that instances where silly glitches in 1979 caused default were enough to raise rates across the board for treasuries by 60 bps for more than 6 months after. This would be the best case scenario in the case of a default. Were it seen as a structural issue in the resolution of American politics, even once, the premium to US debt could be higher, and speculation that is very unhelpful to the US economy could occur. The dollar would perform weakly, and with a de-dollarization trend being a dangerous attack on the US exorbitant privilege, the higher yields could start spiraling into a greater problem.
The risks of any of this end up being remote thankfully, but would be a major stumbling point for American prosperity, much more serious than the Ukraine invasion or COVID-19.
Bottom Line
However, for a longer duration fixed income instrument, the shift upwards of the yield curve due to a premium on rates from Treasuries would be a major source of capital depreciation. IEF may stand well in terms of the macro picture in the US, but this remote risk could seriously injure it. It costs nothing to let the debt ceiling situation float by, so we’re avoiding fixed income instruments until certainty is reached there.
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