The yield is falling. The US 10-year Treasury saw the yield under 4% on August 1st, 2024. The market had a big sell-off due to the weakening US economy. As “interest rates stay at a 23-year high“, now is a good time to look into long-term bonds and find good investments.
I recently used an adaptive approach to build what I called “Wise Wealth Engine (WWE)”. This is to enable investors to profit from the secular growth exposures. In this article, I am going to look into the ETFs that represent the fixed income asset class, specifically the ETFs for long-duration treasury bonds. For income investors, iShares 20+ Year Treasury Bond Buywrite Strategy ETF (BATS:TLTW) looks very appealing because it offers a monthly-paid dividend of over 15%. The volatility of the underlying ETF in its portfolio has become an advantage for TLTW to obtain a reliable source of income. I will show that TLTW demonstrates a resilient price behavior, making it more suitable for investors who need to live off the monthly income from their investment portfolio. TLTW is also a good choice to build WWE, together with other long-term treasury bond ETFs in the portfolio.
TLTW ETF Highlight
TLTW is an actively managed ETF from iShares with the following official goal statement:
ETF seeks to track the investment results of an index that reflects a strategy of holding the iShares 20+ Year Treasury Bond ETF while writing (selling) one-month covered call options to generate income.
For those who are familiar with option trading, TLTW has a single underlying iShares 20+ Year Treasury Bond ETF (TLT) in its portfolio and sells its monthly covered calls to create income distribution. The monthly distribution has a 15.21% yield, which is much higher than the 3.75% distribution from the underlying TLT holding.
The portfolio itself is pretty simple. The major holding TLT accounts for 99.77% of the total portfolio, as shown below. Note that the August call is listed with a strike price of $96 for the current month.
TLTW has a 0.35% expense ratio, which is higher than TLT’s 0.15%. I believe the expense ratio is still reasonable, considering the monthly option activities and the distribution rate exceeding 15%.
The ETF is relatively new, with its inception on August 18, 2022. It has total assets of $978.52M, which is a respectful size given its history of less than 2 years. Recently, TLTW’s trading volume has exceeded 800K, indicating its increasing popularity in the market.
The following is a summary of some key market properties for TLTW ETF.
TLTW is a great way to get income until it isn’t
With the yield curve inverted, investors prefer short-duration bonds for higher yields. Since the inversion is quite unusual, I expect the yield curve to revert back someday. But before that, TLTW’s 15.21% yield certainly looks like an income winner right now.
Notice that the underlying TLT is known for its equity-like volatility, which is a key concern for fixed-income investors. However, TLTW has demonstrated a much lower volatility. Its 52-week HV is 11.6, which is much closer to a typical bond ETF, as shown below.
From a market perspective, TLTW has been in a “sweet spot” because TLT’s stock price has been stuck in a range for the last 12 months or so. The covered call strategy is designed for situations when the underlying price is flat or slightly up. A sideways price move from TLT could also result in a respectful price performance for TLTW. This pattern can be easily verified by the TLTW’s share prices year-to-date. The following is an example when TLT is down about -4.12% while TLTW is down by a similar -4.26%.
Now here comes the kicker, if we add the dividends and compare the total returns, TLTW is up 1.53% beating TLT’s -2.2%. So I would’ve gained more by investing in TLTW than investing in TLT this year.
The following shows another time period during which TLT was slightly up. It can be seen that the total return of TLTW is still better than TLT.
Keep in mind, these are just a couple of cherry-picked backtests. The actual holding time may not match the patterns perfectly, so TLTW could underperform TLT slightly.
I will buy TLTW as a core holding, mainly due to the double-digit distributions and the fact that I would not need to do anything else to keep my income stream going. The distributions from TLT are not sufficient to meet my income needs. In fact, the sweet spot discussed above is my “holy grail” earning machine. I can just keep the 15% distribution, while the capital will manage to maintain its level or even slightly increase.
The key takeaway is that TLTW appears to work well under the current interest rate (stability) situation. What we know is that the rate is likely to go down in later 2024. What we don’t know exactly is when the cut will actually happen and how many rate cuts the FED will be doing. The market has priced in the rate cut in September. So between now and then, I don’t expect drastic moves from TLT in either direction, which makes TLTW a better buy right now.
Why TLT should also be a core holding
TLT has big potential for high returns in an environment of declining interest rates. Now that a September rate cut “could be on the table”, the long duration bonds will start to get the tailwinds they need and attract more money to flow in. I believe now is also a good time to use TLT as a core position to anticipate the eventual rate-decline cycle.
The volatility is high for TLT. Some investors may not feel comfortable holding TLT for the long run. However, as an ETF with substantial volumes in both ETF and options trading, I see the volatility and liquidity (shown below) as advantages for TLT in the market.
TLT pays a monthly distribution with a 3.75% yield currently. While 3.75% is still a “high yield” compared to the market average, it is not enough for investors to live off a 4%-rule withdrawal plan. In fact, I think this is one of the reasons why TLTW ETF was created, to take advantage of TLT’s volatility and the huge options trading activities. Notice that TLT’s option volume was almost 280K, as shown. Please note that investors can also write and sell covered call options to earn more income from TLT holdings, just as TLTW is doing.
As mentioned earlier, passive investors can stick with TLTW as the core holding. However, to take full advantage of a possible rally triggered by the rate cut, TLT will be a better holding in my view, as TLTW’s covered call strategy will impose price caps during the uptrend move.
Build TLT WWE for recession hedge
TLT and TLTW are recession-hedging assets. The economic data reported this week is viewed as weak and suggests a slowing US economy. So it makes a lot of sense to build a “Wise Wealth Engine” with TLT exposures in the investment portfolio.
The following are the recommended WWE settings. Note that the Hedge part will be explained in the next section, together with the rate risk.
- WWE Target Group: 20+ Year Treasury Bond – TLT, TLTW, TMV TMF.
- Dividend Capturer: TLTW. Invest the (part) monthly income in Core TLT.
- Core Engine: TLT with dividend reinvested. TLTW without reinvest.
- Hedge: TMF, TMF. TMF/TMV’s dividend is invested in Core.
- Optional Income Capturer: TLT covered calls. Invest premium to Core.
- Optional Income Capturer: TMF/TMF covered calls. Invest premium to Core.
Note that TLT is used as a Core for the rate-decline (cycle) thesis. TLTW can be used as a Core for the current rate regime. The new investing activities (from the distribution and premium) can be done based on one’s own time availability, although doing it every month is a reasonable schedule if writing/selling calls is planned.
Use TMV to hedge “higher-for-longer” risk
I believe the so-called “higher-for-longer” rate regime presents the main risk to long-duration bond holdings in the portfolio. Recall that the rate-hiking was the reason why the long bond collapsed in 2022.
I wrote an article about Direxion Daily 20+ Year Treasury Bear 3X Shares ETF (TMV) three months ago. I highlighted two key features: hedge and income. TMV remains a good hedge tool in the WWE portfolio with TLT and TLTW as core holdings, as listed in the earlier section.
TMF is the opposite leverage ETF, it is 3X bull on TLT. Readers should take a look at the mentioned article for more details. The TMV/TMF dual play should work well in the WWE setup, as both can produce dividends and stabilize the whole volatility of the combined holdings.
One interesting question is about the weights for the dual play and the TLT/TLTW positions. While I am still working on it with my own portfolio, I believe the answer really depends on one’s own judgement over the current “rate-cut” saga. However, I will share the following to provide some insight.
It can be seen from the chart below that TMV will perform fine when TLTW is doing relatively well. More specifically, in the areas highlighted with blocks, TMV ended up higher as a price gainer. Notice that TLTW actually outperformed TLT during the same time periods. Recall the “pattern” discussed earlier, this is the time when TLTW price is closely tracking or even outperforming TLT. Notice in this case, TMV would work as a performance gainer instead of a hedger. If TMF is included in the portfolio at the same time, it will actually play the hedging role.
The key takeaway here is that the weights and hedging may not matter too much under the current macro conditions. It would be very simple to start only TLTW and TLT Core positions with equal weights. I will provide more updates on this when there are significant changes with the rate cuts.
High risks for triple leveraged ETFs
Both TMV and TMF are highly leveraged ETFs, and the share prices may suffer from big value erosions over longer time periods. Investors should read the risk statements carefully before investing in TMV and/or TMF. Keep in mind that these leveraged ETFs are designed for short-term trading alternatives. There is a FINRA regulatory reminder regarding leveraged ETFs. Investors should also read it before trading any shares of the leveraged ETFs.
Closing Thoughts
TLTW is a long treasury bond ETF with a strategy to write covered calls to generate a high yield of 15%. It is very likely that the rate decline cycle could start when the first rate cut happens. The long duration treasuries will be a big beneficiary. I recommend a BUY on TLTW. It can be used to set up a long-term portfolio together with TLT as a core holding. TLTW can weather the current high but steady rate conditions, while TLT will provide great returns when rates are declining. Investors should keep a high alert on the “higher-for-longer” risk before making investments in any long-duration bond ETFs.
Read the full article here