EDV – Moving from sell to hold after 25% drop (NYSEARCA:EDV)

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Thesis

Vanguard Extended Duration Treasury ETF (NYSEARCA:EDV) is an ETF that invests its cash in long-term Treasury securities. The fund has a very long duration of 24.4 years and has been negatively affected by the current cycle of monetary tightening. Last overdue year we wrote a article where we detailed why we were assigning a To sell classification at EDV. Our call turned out to be the right one, with the fund down more than -25% since our article against our anticipated move of -20%.

With a very authoritarian Fed convincing the market to aggressively reprice the yield curve upwards, we believe most of the rate move is now behind us. EDV’s performance is being driven by 30-year rates and we believe most of the movement for this point on the yield curve has already been made. While there may still be room for slippage of up to 3.5% in 30-year yields, the aggressive 200 basis point rise seen earlier in the year will not be repeated. So we go from To sell for Hold on EDV, and pending the stabilization of rates later in the summer in order to give the fund a buy signal.

Performance

EDV is down more than -25% since we gave it a To sell Evaluation:

Evaluation

original note (Looking for Alpha)

As we mentioned in our original article:

With the Fed poised to raise rates three times next year, buying a high-duration bond fund is not optimal. In fact, we expect EDV to lose value next year, mainly due to its long maturity profile. After spending nearly two years at another low in interest rates, we expect inflationary pressures building up in the economy to cause interest rates to rise steadily, putting pressure on funds long-term Treasury. We are bearish EDV until the end of the structural tightening cycle.

[..] If we look at the past performance during the last tightening cycle (2013-2014), we can see that the fund lost almost -20% during the initial phases

Our call proved correct with the fund down -25% since our article. We believe that long-term bond funds such as EDV are the cornerstone of a well-balanced portfolio, but they must be actively traded in a changing monetary cycle, namely a tightening cycle. Going long while the Fed is very active in fulfilling its dual mandate is not an optimal choice and has proven to be a major effort to drain money through EDV.

Assets

STRIPS stands for Separate Trading of Registered Interest and Principal of Securities. This means that historically, investors looking at Treasuries have decided that only certain aspects meet some of their needs (i.e. only the interest component or only the principal component) and decided to strip the original Treasury security into underlying cash flows with their own identifiers. Basically, STRIPS allow investors to hold and trade the individual interests and principal components of eligible treasury bills and bonds as separate securities. For example, a 10-year treasury bill consists of a single payment of principal, due at maturity, and 20 interest payments, one every six months over 10 years. When this note is converted to STRIPS format, each of the 20 interest payments and the principal payment become a separate security.

The portfolio contains only 80 bonds, but has a very long duration:

wallet

Wallet features (Fund Fact Sheet)

We can see from the fund’s factsheet that the composition of STRIPS allows portfolio managers to create a very long-dated portfolio with a duration of around 25 years.

The fund falls into the long-term treasury bill category as quantified by Morningstar:

duration

Bond Style (Fund Fact Sheet)

The portfolio is entirely composed of risk-free securities:

funds

Assets (Fund Fact Sheet)

The fund’s engine is composed exclusively of rates since there is no credit risk in the underlying Treasury securities.

Interest rate

30-year yields are approaching their 2018 highs at 3.43%:

fed

Rates over 30 years (The Fed)

Earlier in the decade, long-term rates peaked at 3.93%. We believe that we will review the levels of 2018 but not those of 2013. Ultimately, the trend in rates is driven by the Fed and its tightening of financial conditions in order to contain inflation. We believe the market has already done this, and as Goldman Sachs illustrates, financial conditions are on track to reach constrained levels:

Goldman

Financial conditions (Goldman Sachs)

With stagnating leading indicators and escalating recessionary talk for 2023, the Fed doesn’t have much wiggle room. In our view, the rate hike is closer to completion than the market is anticipating. The Fed wanted mortgage rates to rise to cool the housing market, and they did. Once they begin to unwind MBS balance sheet holdings, mortgage rates will continue to be constrained.

While corporate balance sheets are healthy and the need to place long-term debt at these higher levels will be moderate over the next few years, rising long-term rates will weigh on new capital projects and investments. It will take a few months for the higher rates to trickle down to the real economy, but in our view, any overshoot of 4% will have a significant impact on the economy.

More market analysts now believe that the bulk of the rate hike is now behind us:

Rates

Rates (Black rock)

With BlackRock and Morgan Stanley in the camp of an implied rate normalization by current market levels, investors should start thinking about reducing short positions in Treasuries.

The Fed calendar and auction schedule for next week are:

Fed calendar:

  • May 23: Atlanta Fed President Raphael Bostic, Kansas City Fed President Esther George

  • May 24: Fed Chairman Jerome Powell

  • May 25: May 3-4 FOMC Meeting Minutes, Fed Vice Chairman Lael Brainard

Auction schedule:

  • May 23: 13 and 26 week invoices

  • May 24: 2-year warrants

  • May 25: 2-year floating rate notes, 5-year notes

  • May 26: 4 and 8 week vouchers, 7 year vouchers

Conclusion

EDV is a long duration Treasury STRIP securities vehicle. The fund has been decimated by the violent rise in interest rates, with a performance of around -25% since the start of the year. With the bulk of the rate movement now behind us and an aggressive repricing of the yield curve, most of the negative price movement in EDV is behind us. So we go from To sell for Hold on EDV, and pending the stabilization of rates later in the summer in order to give the fund a buy signal.

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