A Story About The 10YR UST, The Yield Curve, And The TYA ETF (BATS:TYA) #NewsETFs

Introduction

The Federal Reserve Bank, back in 2022, began raising the Federal Funds Rate, the determining interest rate for almost all other rates in the US. The Federal Funds Rate sets the floor (I’m glossing over a lot of economics here) for loans in the US. This includes debt issued by the US government itself, which must issue new debt at the prevailing rates.

This is demonstrated by charting the effective Fed Funds rate against the 1-month US Treasury rate. They move in tandem.

Duration and Interest Rates

The prices of treasuries are affected by changes in their interest rates. It goes, typically (there will always be an exception, but this is true for the majority of cases), like this:

• If interest rates rise, the prices of bonds fall.
• If interest rates fall, the prices of bonds rise.
• A bond’s “duration” is a measure of how sensitive it is to interest rate movements.
  • The farther out the maturity of a bond, the higher its duration.
• The higher the duration, the more sensitive the bond will be to rate changes, and the more sharply its prices will rise and fall.
  • We can reasonably expect a 3-month UST to be less volatile than a 5-year UST because the 5-year UST will have a higher duration, since it matures at a later date.
    • This is visualized below using two ETFs, one that tracks the 5yr UST, XFIV, and one that tracks the 3mo UST, TBIL.

Bond ETFs

When the Fed began hiking interest rates in 2022, bond funds with high duration took a significant beating.

This has led a lot of folks to begin recommending adding duration to bond portfolios right now, including myself.

If we are to return to a world with 2-2.5% rates in a few years, as the Fed currently projects, we should reasonably expect to see appreciation on these funds back up to their previous levels. For the funds above, that represents a significant retracing of losses for existing investors and great potential upside for new investors. The longer the maturity you’re willing to go, the more upside potential there is.

The Yield Curve

When we visualize treasury bonds, notes, and bills of different maturities with their respective yields, we get a curve that can be plotted onto a chart. This helps investors understand what yields they have available to them, but also for what length of time. Typically, in the ZIRP world that we’ve been in since the great financial crisis, the yield curve looks like this:

The reason it looks like this is that it is typically more likely for rates to be higher in the long term than they are currently.

However, since the Fed has signaled that rates are at their peak and will only go down from here, the current curve is inverted. Right now, the market is expecting long-term rates to be lower than current short-term rates. Our current yield curve looks like this:

If you want a high yield on US treasuries, you need to be buying shorter term bonds. The 10yr UST is currently sub 4% while the Fed Funds Rate (the blue band in the chart above) is at 5.25–5.5%.

This is a problem if you want to take advantage of the duration trade from the last section, as it means you will be getting sub-par interest rates on your bonds with no guaranteed upside. There are risks to the duration trade that could leave investors holding these bonds for a very long time if the Fed has to halt its planned rate cuts.

It’s at this point where I hope I’ve built the foundation for my readers to ask, “How can we have both?”

The nice guys over at Simplify have us covered. If you haven’t read their work on Seeking Alpha, I recommend it. They have some really smart people working over there. Very specifically, I recommend this article from two years ago when Simplify called this trade and walked through its mechanics from a different perspective than I am here.

The Simplify Intermediate Term Treasury Futures Strategy ETF (BATS:TYA)

Exploiting these two trades at the same time is surprisingly easy if you are an institutional or sophisticated investor, buy the 10yr UST future. TYA is an ETF that launched in 2022 and does just that; it holds and rolls futures on the 10yr US Treasury.

One of the beautiful things about futures is that they can be purchased on margin, secured by some kind of collateral, and therefore can provide leverage very easily. TYA uses T-Bills (0-3 months), which are the highest-paying treasuries on the curve right now, to secure the purchase of 10yr UST Notes. Its holdings look like this:

Note the 290% weight of the 10yr Note.

This setup divorces the yield on the holdings from the duration on the holdings. The duration increases with the leverage, exposing the ETF at a duration of 15-20 over the expected 10.

When you plot a typical yield curve (remember our example of the nice, happy, normal curve), TYA’s placement on it looks like this:

We can see this in action mapping the price and yield changes of the ten-year duration, using XTEN, T-Bills using TBIL, against TYA.

Note that there is very little difference in how TYA correlates between intermediate and long-term treasuries, at least for now. They all move together, but we can see from the charts above that TYA is far more volatile than the 10yr duration on its own. If the duration trade plays out as the market (and I) expects, TYA should benefit more than the unleveraged funds while maintaining a higher yield.

As an example, here is a hypothetical of how we may expect TYA to react to a 100bp decline in the Fed Funds Rate due to the leverage.

Click to enlarge

Timeline for the TYA Trade

The next question is, how long will this trade take? We don’t know, since it relies on the assumption that the Fed will act a certain way (lowering rates to 2-2.5% in the long term).

The Fed’s current prediction plot looks like this:

The tough part of this prediction is that not only does the Fed not agree with each other very often, they also change their mind frequently. These projections could change based on any number of new economic data points released between now and 2026.

The market also likes to speculate on timelines, so here is their take on where and when rates are headed:

These tables are, for the most part, in agreement about the timeline from here. We should expect our first 100bp worth of rate cuts by January and then another 100bp throughout 2025, potentially with a few months of holding rates as needed.

Returns for the TYA Trade

This means investors could be looking at a 20% CAGR just in duration-related exposure to the 10yr bond via TYA.

This excludes other factors that contribute to bond pricing, coupons paid (and lack thereof for the futures contracts) by the underlying T-Bills in the portfolio, and unexpected changed in behavior brought on by new variables such as an asset crash or bad economic data.

Conclusion

The Federal Reserve is likely to drop rates next month, and continue doing so until they hit their long-term target of 2-2.5%. Meanwhile, investors are able to capture the upside of the resulting trade best with 10yr UST futures. This allows investors to maintain a higher yield than the 10yr UST, while also benefiting from increased duration above the 10yr UST. This is best achieved via Simplify’s Intermediate Term Treasury Futures Strategy ETF (TYA) because it gives capital efficient access to futures, with enhanced systematic rolling, and a modest expense ratio of 0.25%.

I am a holder of both ends of this trade via TYA and its sister fund, the Simplify Short Term Treasury Futures Strategy ETF (TUA), and I am planning to hold on to these for the foreseeable future as rates begin to drop.

Thanks for reading.