IEI: attractive yield, decent risk-adjusted returns ahead
There has rarely been a worse time to invest in Treasuries than 2022 – and that’s not cheap rhetoric.
Long-term government bonds (VUSTX) are in their the deepest withdrawal from the past 35 years at least (i.e. as far as I can verify). The current pullback has been happening since Treasury prices peaked as early as three months into the COVID-19 pandemic, which seems like two lifetimes ago. Down 12% so far in 2022, and assuming the status quo over the next few months, Treasuries could be on track to their worst year of returns in the history of the Great Depression after the 1930s.
With inflation soaring and the Federal Reserve still unclear on its roadmap for higher short-term interest rates, holding high-quality fixed-income instruments seems like a terrible idea. . But for the reasons outlined below, it might be an opportunity to hold a fund like the iShares 3-7 Year Treasury Bond ETF (NASDAQ: IEI) at a price that makes sense.
What is the IEI?
Let’s first start by reviewing very briefly the basics of this ETF. The iShares 3-7 Year Treasury Bond fund currently holds more than 60 treasury bills and strips with varying maturities ranging from 2.9 to 6.9 years. The effective duration of the fund is almost 5 years and the average yield to maturity is 2.59%.
IEI charges a management fee of 15 basis points, which is neither outrageous nor a bargain, given the fund’s low risk-reward profile. The ETF, with an AUM of $10.5 billion, trades on average around 1.75 million shares or $210 million per day, making it highly liquid.
Good return, low risk, diversification
A few months ago, I explained how bond fund returns tend to track long-term returns very closely. Today, the five-year Treasury yield stands at 2.49% (see blue line below), which is both the highest in the post-pandemic era and the highest than it has been for most of the past 10-12 years – with the exception of a few months in 2018. Therefore, an investor who buys IEI and holds the position until 2027 can reasonably assume average annual returns higher than historical by approximately 2.5%.
To be fair, IEI’s expected single-digit gains are far from exhilarating. But keep in mind that the five-year yield is currently higher than the 10-year rate of 2.40% and almost as high as the 30-year rate of 2.52%. For much lower duration risk, and despite inflation still projected at a rich 3.4% through 2027, the gains here could be considered decent given so much geopolitical and macroeconomic uncertainty today.
While IEI’s projected absolute returns may not look great to many, the ETF’s risk-adjusted performance could be better than what investors might be able to find elsewhere. Historically, the five-year fund has produced a rolling 12-month volatility of 3.6% since inception and 2.9% over the past decade (see chart below), which even includes periods of tightening fairly aggressive monetary policy. At these low levels of risk, projected returns of 2.5% and a Sharpe ratio of around 0.5 to 0.7 may start to look compelling.
Dip buyers may also see an opportunity here. Just last week, on March 25, the IEI hit an 8.4% pullback from its all-time high in early August 2020. This is the steepest pullback in the long history of 15 years of the fund. It should be noted that the IEI has never produced forward one-year returns below 6.7% after a pullback of 5% or more.
Finally, I find IEI compelling for its diversification benefits. Like medium and long-term treasury funds, this ETF has historically negatively correlated with stocks: -0.33 since inception and -0.27 over the past decade. Combining IEI with the S&P 500 (SPY) or adding it to a portfolio exposed to leveraged equity funds could lead to better returns, both in absolute and risk-adjusted terms.