The first three quarters of 2023 were challenging for investors in treasury bond ETFs as the US Federal Reserve’s rate hikes impacted returns, although the last quarter offered significant relief. Despite the negative returns through the first three quarters of 2023, treasury bond ETFs had consistently strong inflows throughout the year. This investor interest was across the duration spectrum; longer duration (10+ years) treasury bond ETFs took in $42 billion in net inflows in 2023 compared to $26 billion for ultra-short duration (less than one year) treasury ETFs, despite the former being more sensitive to rate hikes.
This apparent contradiction between weak returns and strong flows in Treasury bond ETFs last year is best highlighted by the iShares 20+ year Treasury Bond ETF (TLT). It took in $17 billion in net flows in the first three quarters of 2023, despite being down 9% year-to-date through that period. The ETF also saw a sharp increase in trading volume last year (Figure 1), becoming the most traded bond ETF in the U.S. in the six-month period ended December 29, 2023.
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Institutional Investors Buying the Dip
The surge in TLT’s trading volume and assets under management has largely been driven by institutional interest, indicating that the ETF is viewed as an opportunity to “buy the dip” on long duration treasury bonds. Figure 2 shows the performance of TLT during the January 2023 to October 2023 period, from a starting base of 100. Periods of decline in TLT, typically after Federal Reserve funds rate increases by the U.S. Federal Reserve, were accompanied by three to four subsequent weeks of inflows, usually in the range of $3.5 billion to $5.0 billion.
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One of the primary investment theses behind these inflows was the anticipation of the Federal Reserve ending rate hikes. For example, TLT declined by 6.4% between the two FOMC meetings on February 1, 2023, and March 22, 2023. This was followed by a six-week period in which there were $3.5 billion of net new creations in TLT shares. There were similar inflows in the four weeks starting May 8 and the five weeks starting on June 26, 2023.
Investing in TLT in anticipation of an end to rate hikes proved to be difficult for investors last year. TLT continued to decline through mid-October 2023 as yields stayed high due to stronger-than-expected labor market conditions and inflation being persistently higher than the Federal Reserve’s long-term target rate. Improved inflation numbers in the last two months of 2023 finally offered some relief, with TLT rallying in response to renewed expectations of an end to rate hikes, and potential rate cuts in 2024.
A historical review of the CME’s FedWatch indicator highlights the difficulty in forecasting the Fed’s announcements. The FedWatch tool from the CME estimates the probabilities of possible Fed funds target rate ranges based on Fed funds futures contract prices. It assigns probabilities for the different target rate ranges, assuming that rate hikes/cuts are uniformly sized in increments of 25 basis points (0.25%) and that the Effective Federal Funds Rate (EFFR) will react proportionally to the size of the hike/cut. Table 1 shows that for some rate hikes, such as the ones in March 2023 and May 2023, the probability based on futures prices was inaccurate in predicting the final target rate range. It underscores the difficulty in forecasting rate paths and the complexity in accurately predicting a market top in rates.
Categories of Institutional Buyers
TLT inflows, in part, have been driven by allocations from ETF model providers. Model providers will turn over a portion of their portfolio several times a year in response to the macro environment. At the beginning of 2023, model providers allocated heavily to short-duration treasuries to position for what seemed like an uncertain geopolitical landscape. Throughout the year, there was an unwind of this shorter duration allocation in products, such as the iShares U.S. Treasury Bond ETF (GOVT) and a movement into longer dated treasuries, specifically TLT.
The month of July was highlighted by slightly higher volumes of TLT, but substantial inflows into the ETF. July saw $4.9 billion in inflows, whereas May, the second-highest month of 2023, saw $3.4 billion. Much of these inflows can be attributed to a combination of ETF model providers and the registered investment advisor (RIA) community.
Another segment of institutional interest in TLT was from the pension fund community. Pensions based in Latin America were the most notable region to build positions in TLT over 2023. Relative to more short-dated treasury ETFs, the pension funds in Latin America’s allocation skewed heavily to long-dated treasury exposures throughout 2023. Said another way, there was less activity for this region when looking at other popular treasury products along the curve like SPDR Bloomberg Barclays 1-3 Month T-Bill ETF (BIL), iShares 1-3 Year Treasury Bond ETF (SHY), and iShares 7-10 Year Treasury Bond ETF (IEF).
While TLT volumes picked up significantly in October 2023 (Figure 3), institutional activity wasn’t the sole driver of this uptick. By looking at the TLT options market, one can better see the catalyst for this heightened volume. In October, there was an explosion in TLT open interest contracts. This translates to increased volume in the TLT cash market as the option’s delta needed to be hedged by market makers with TLT itself. It’s also worth noting that the increase in options volumes was from both retail and institutional channels. This October volume—which equates to $99 billion traded—is a notional record for fixed income ETFs in a single month.
Additionally, there are certain high volume or high inflow days in TLT that are worth noting. On October 19, 2023, TLT traded 87 million shares. Several weeks later, on November 9, 2023, it traded nearly 89 million shares. On a notional basis, this is $7.3 billion and $7.8 billion, respectively. Neither of these days coincided with FOMC rate decisions or significantly outsized volumes in broader fixed income markets. However, on both October 19 and November 9, TLT options’ open interest was at 5.5 million, its highest amount of the year, confirming the role of options in driving TLT trading volume.
Conclusion
As we start 2024 and the Federal Reserve makes pivotal rate decisions, TLT is a noteworthy instrument to track. Its institutional adoption, 2023 inflows, heightened volumes, sensitivity to interest rates, and robust options market all make it a multifaceted ETF. Additionally, January tends to be a month when investors reassess their portfolio and make changes for the year ahead. We expect TLT to be at the forefront of this activity in this new year.
This commentary is provided for informational purposes only and does not constitute financial, investment, or trading advice. The information is provided "as is" and neither Flow Traders nor its affiliates guarantee the accuracy, sufficiency, or completeness of this content and disclaim liability for any errors or omissions. Any past performance discussed above cannot be used to estimate and/or guarantee future results. Flow Traders is not affiliated with CFRA Research or WealthManagement.com
