TLT Crushes BIL, ‘Risk-Free Rate of Return’
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What a difference a year has made in the fixed-income market.
At this point last year, the Federal Reserve had not yet signaled it was ending the fastest rate hike campaign in history, part of its campaign to fight the worst inflation in four decades.
With inflation still running hot, the bond market proxy, the iShares 20+ Year Treasury ETF (TLT), was still dropping like a rock and would eventually reach its bottom in October after falling 50% from its Aug. 2020 high.
In the face of historic inflation and interest rates, why would have anyone invested in such a rate-sensitive ETF one year ago? The answer is price appreciation potential.
Today, that potential is realized as TLT’s price is 10.8% higher than it was 12 months prior, rewarding risk-averse investors who bought shares of the long-term Treasury bond ETF last year.
TLT vs BIL and the ‘Risk-Free Rate of Return’
A year ago, some investors and analysts opined that Treasury bills—often referred to as a benchmark for the “risk-free rate of return,”—were the smarter fixed-income security to park money while inflation was running hot. At the time, this was sound logic, as the rate, as measured by the SPDR Bloomberg 1-3 Month T-Bill ETF (BIL), was slightly above 5% then.
In the investment community and corporate finance, the risk-free rate of return is the theoretical return on an investment with zero risk. In practice, it's often approximated by the yield on a U.S. T-bill, as these securities are considered to have minimal credit risk.
The risk-free rate is also used as a benchmark to assess the expected return of riskier investments. The higher the expected return of an investment relative to the risk-free rate, the greater the risk premium associated with that investment.
Thus, an investor buying shares of TLT this time last year may have chosen the long-term Treasury bond ETF as a means of beating the risk-free rate of return, as longer-term bonds are expected to have greater price appreciation in a falling-rate environment. But the rate sensitivity works both ways: if rates remain elevated or go higher along with hotter inflation, TLT and funds like it would have steeper declines.
As of this week, TLT investors can say their willingness to take the interest rate risk paid off, as the fund’s 10.8% one-year return doubles that of BIL’s 5.4% performance