Trackers and index funds are the logical choice for investing in US government bonds. Indeed, within long-term dollar bonds, the scope for active management is limited.
Short-term US government bond yields have fallen below long-term yields - in other words, the so-called ‘inverted yield curve’ of recent years is no more, so more and more investors are considering longer-term government bonds.
Yields on short-term bonds tend to be lower than those on long-term bonds because lending over a longer period carries more risk. Over the past two years, however, the situation has been the opposite, and the recent change in the yield curve seems to indicate increasing investor concerns about a possible recession in the US.
As the chart below shows, recessions typically begin when the yield curve is no longer inverted. In such a scenario of slowing growth and falling inflation, policymakers are expected to cut interest rates, making it more attractive to hold long-term bonds.
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Government bond ETFs are popular
Investors looking to secure current bond yields before they start to fall are investing mainly in trackers. In the US, iShares’ 20+ Year Treasury Bond ETF (ticker: TLT), the largest ETF tracking long-term government bonds (with a maturity of 20 to 30 years), fetched some USD 11.2 billion over the first eight months of this year. This highly interest rate-sensitive tracker is considered a safe haven during recessions, but lost as much as 45.7 per cent of its value, measured in dollars, between April 2020 and October 2023. As much capital is in money market funds, it is expected that even more money could flow into long-term government bonds once the Fed cuts interest rates.
In Europe, things did not go so well yet. Although USD government bond funds raised around EUR2bn over the first seven months of 2024, inflows into very short-term USD government bonds were more than double. iShares’ $ Treasury Bond 7-10yr and 20+ ETFs, both receiving a Morningstar Medalist Rating of Silver, are popular vehicles to gain exposure to long-term US government bonds. This is not surprising as there is little scope for active management within this asset class.
Indeed, the ability to add value relative to simple index tracking is largely limited in this asset class to active choices on duration. This is confirmed by the results of Morningstar’s latest Active/Passive Barometer study. Over the past 15 years to the end of 2023, less than 10 per cent of active managers within the USD government bond asset class managed to outperform their passive counterparts.
Exchange rates
For euro-centric bond investors, currency considerations are crucial when investing in government bonds outside the eurozone. In recent years, the strong dollar provided support when investing in US government bonds, but the USD is now significantly overvalued on a purchasing power parity basis.
According to some analysts, the Fed’s first interest rate cuts will ‘signal the beginning of the end’ of the dollar rally. This super rally began after the end of the 2008-2009 financial crisis and was further fuelled in recent years by a cocktail of accommodative fiscal policy and tight monetary policy in the US. With price pressures easing and growth poised to slow, the dollar is coming under pressure.
Whether the recent weakness (USD/EUR -2.6 per cent and USD/JPY -11.3 per cent since the end of June) will actually continue remains difficult to predict. According to a majority of currency strategists polled by Reuters, the recent decline is likely to stagnate over the next three months. They say expectations for interest rate cuts are too high, while few indicators point to an impending recession. Moreover, historians remind us that the last two dollar rallies ended only after coordinated intervention by several central banks.
Fund radar
The strategies that appear prominently on Morningstar’s radar either have a strong management team and a robust investment process in the qualitative opinion of the fund analysts, or these qualifications are attributed based on an algorithm that evaluates mutual funds based on the same framework. In this article, we highlight a fund within the USD government bond category that meets these criteria and is followed by Morningstar analysts.
Vanguard U.S. Government Bond Index Fund
Vanguard U.S. Government Bond Index Fund is an excellent option to gain broad exposure to the world’s largest government bond market. The index fund receives a Morningstar Medalist Rating of Silver from Morningstar analysts.
The strategy tracks the Bloomberg US Government Float Adjusted Total Return Index representing US government bonds, with a small overlay of bonds issued by various government agencies, but these rarely make up more than 5 per cent of the portfolio. In short, this is a classic buy-and-hold investment that can be used by European investors to complement bonds of eurozone countries.
The fund is efficiently managed by a team of eight managers and traders who are adept at managing passive bond strategies. Most of their time is spent compiling the sample basket, tracking and analysing trading opportunities around routine rebalancing.
The fund’s performance is best assessed over longer periods covering different phases of the monetary policy cycle. The fund lagged behind sector peers who, once the US Federal Reserve started raising interest rates, shifted their focus to shorter-maturity bonds.
Over longer periods, the fund managed to present above-average risk-adjusted returns, helped by its low costs. The fund’s volatility is in sync with the benchmark and tends to be below the category average as several competitors are moving more heavily into MBS market and are more exposed to credit risk.
Thomas De Fauw is manager research analyst at Morningstar. Morningstar analyses and evaluates investment funds based on quantitative and qualitative research. Morningstar is one of Investment Officer’s knowledge partners.