What it TMF ETF?
In the last few months, especially last three weeks, TMF (Direxion Daily 20+ Year Treasury Bull 3X Shares) have attracted much attention, amid high market anticipation of Fed rate cuts in September.
TMF is an exchange-traded fund designed to provide daily investment results, before fees and expenses, that correspond to three times (300%) the daily performance of the ICE U.S. Treasury 20+ Year Bond Index, which tracks the performance of long-term U.S. government debt with maturities of 20 years or more, excluding certain securities like inflation-linked bonds. (The index is rebalanced monthly based on market capitalization adjusted for Federal Reserve holdings.)
TMF is kind of leveraged version of TLT (iShares 20+ Year Treasury Bond ETF) is one of the unleveraged versions of TMF. We have an article talking about TLT EFT before.
As its full name indicates, TMF is a “bull” ETF, meaning it benefits from rising prices in the underlying bonds, which typically happens when interest rates fall. (By the way, It has a inverse twin, or the bear version called TMV.)
In the last 30 days since 9th July, TMF showed an positive return of around 12.36% compared to the -4.17% performance of S&P 500 (SPY). This is especially after the Federal Reserve Chair Powell said September interest rate cut could be ‘on the table’ as inflation cools on July 30th, according to Associated Press reports.
In contrast to SPY’s stable performance, TMF was relatively volatile, with significant ups and downs, peaking around early August before declining slightly.
Source: Seekingalpha.com
Over the long term, TMF shows a drastic decline with a total return of approximately -79.43%, when SPY has an 83.11% growth.
Source: Seekingalpha.com
TMF holdings
Reviewing the holdings of TMF (as of August 9th 2024), we find there are three major types of holdings:
There are cash or cash-equivalent holdings such as Dreyfus Govt Cash Man Ins, Dreyfus Trsry Securities Cash Mgmt, and Goldman Finl SQ Trsry Inst 506, amounting to $2.22 billion. They usually represents very low-risk, short-term investments.
Besides, TMF holds directly a significant amount of TLT with market value of $4.2 billion, as part of its strategy to achieve its targeted exposure to long-term U.S. Treasury bonds.
Last, there are various swap agreements that TMF has entered into to gain leveraged exposure to the performance of the TLF ETF in the holdings. The total market value of all the swaps listed is $14 billion.
These are the key components where TMF can achieve 3x leverage on the daily returns of TLT. Each of the listed swaps corresponds to a different counterparty or set of terms, indicated by the different security identifiers (e.g. TLTU, TLTJP).
How does TMF ETF work?
It amplifies the returns of the underlying index by a factor of three, through financial derivatives such as futures contracts and swaps (as demonstrated in its holdings).
For example, if the underlying index goes up by 1% in a day, TMF is designed to go up by approximately 3%. Conversely, if the index falls by 1%, TMF would fall by about 3%.
With swap agreements, TMF agrees to pay the counterparty a certain fixed interest rate or other payments, and in return, the counterpary agrees to pay TMF a return based on the three times the daily performance of the TLT (as the targeted exposure or other exposure shown in the holdings).
It runs on a daily reset mechanism that the swap is typically reset daily to ensure the 3x leverage is maintained. If the TLT drops, TMF will owe payments to the counterparty, again three times the index’s loss.
This allows TMF to achieve leveraged exposure without needing to deploy three times the capital directly into the bonds or ETFs. It is also an flexible way as it can be structured to closely match the fund’s objectives.
To manage risk, both parties often post collateral. That’s why you can see TMF hold cash or cash equivalents as collateral to back up its obligations under the swap agreements.
Is TMF safe?
As TMF is trying to track the TLT closely, the latter’s performance is significantly affecting TMF’s.
We mentioned in another article specifically for TLT that it poses various risks for investors, some of which are also threatening the returns of TMF.
Macroeconomic risk: Interest rate and inflation
As its underlying TLT is linked to Treasury bonds, TMF is highly sensitive to changes in interest rates. Long-term bond prices fall when interest rates rise, which would cause TMF to lose value. If the Federal Reserve or other central banks raise rates to combat inflation lasting for months, or for other reasons, TMF would suffer significant losses.
As it is demonstrated before, its price has dropped from the peak at $460 in July 2020 to about $39 in October 2023 and yet to recover.
If interest rates rise unexpectedly or faster than anticipated, the value of long-term bonds, and thus TMF, can drop sharply. TMF investors are particularly vulnerable to sudden shifts in interest rate expectations.
Macroeconomically, the U.S. fiscal deficit and national debt have increased substantially under last few presidential administrations, with debt-to-GDP ratio reach 122% this year. During Joe Biden’s tenure, it has increased around $5 trillion and surpassed $35 trillion two days ago. The potential for more bond issuance could lead to higher interest rates if demand for government debt is insufficient.
Source: Fred
Source: Fred
On the other end, if inflations rises and the Federal Reserve does not raise interest rates sufficiently, the real (inflation-adjusted) returns on bonds, and consequently TMF, can be regative.
More importantly, even before inflation manifests in official data, if investors anticipate higher inflation, or inflation data comes in higher than expected, it could lead ot fears that the Fed might not cut rates aggressively, putting downward pressure on TMF.
However, it should be noted that TMF performance is not always inversely related to interest rates. TMF saw significant gains during the last rate cut cycle from 2019 to 2020, rising from $150 to $580. However, during the 2009-2015 period, despite rate hikes, TMF remained stable and even grew, highlighting its potential in various rate environments.
After 2020, TMF’s sharp decline was primarily driven by the Federal Reserve’s aggressive rate hikes in response to persistent inflation, which led to a rapid increase in interest rates. This, combined with TMF’s leveraged structure, which magnifies losses in a rising rate environment, resulted in significant losses.
Additionally, market dynamics such as forced selling of long-term bonds, a shift in investor sentiment towards equities, and the overall unfavorable environment for long-term bonds contributed to TMF’s steep decline.
Leverage Risk: Leverage decay
It is noted that in the longer term, the 3x leverage is not exactly 3x, but faces gradual erosion with more fluctuations.
Because swaps are marked to market daily, meaning that value of the swaps is recalculated based on the daily changes in the underlying index. Any gains or losses are settled daily. Over time, the daily resetting of swaps and compounding effect can cause the performance of the ETF to drift from three times the long-term performance of the underlying index.
In addition, as swaps involve costs, including fees to the counterpary, managing them adds complexity to the fund’s operations.
Here is a simple example.
Assume both TMF and TLT start at $100 on day 0.
On day 1:
TLT gains: 10%
TLT price: $100 + $100 * 10% = $110
TMF gains: 30%
TMF price: $100 + 30% of $100 = **$130**.
On day 2:
TLT loses: 10%
TLT price: $110 – $110 * 10% = $99
TMF loses: 30%
TMF price: $130 – 30% * $130 = $91
In the two days, TLT only loses 1% ($100-$99), but TMF actually loses 9% ($100-$91).
In summary, the leverage is effective on a day-to-day basis, but over longer periods, the compounding effects of daily resets cause the leveraged ETF to deviate from a straight 3x relationship.
This can lead to underperformance relative to the expected outcome. This is known as “leverage decay” or “volatility decay”.
The followings are two more charts about the leverage decay in a longer term with more fluctuations. Both are fluctuating with 2% changes each day. But the first one increased first and the second one decreased first.
In both cases, we can see that in the longer term (from day 0 to day 20), TMF show a much higher decrease percentage, but a lower increase percentage than TLT.
Though we can see the leverage is multiplied in chart 3 if the TLT keeping increasing 2%, the sustainable increase is not quite practical. Besides, we haven’t considered the erosion in paying fees in our portfolio.
Besides, we need to consider the fees and expenses. As the Direxion website indicates, the TMF’s daily investment results of 300% is calculated before fees and expenses.
As TMF’s expense ratio is 1.04%, so we daily fees is about 0.00285%
If the daily return of TMF is 5% gain in a single day, representing 300% of the index’s daily return, the final return might be 5% – 0.00285% = 4.99715%. Although the daily 0.00285% fee looks small, the compounding effect of this minor reduction could be much bigger than 1.04% overall.
Source: Direxion
As we predicted below, investors who hold TMF for extended periods, especially in volatile or unpredictable markets, may experience significant losses. The divergence between expected and actual performance due to compounding also adds up the uncertainties.
Risk: Management and operation
There are also risks from the counterparty and the management sides.
For example, if the counterparties to the swaps fail to meet their obligations, TMF would suffer losses. While the risk is typically managed through collateralization, it still present a potential source of risk for investors.
Operationally, TMF does not perfectly follow its underlying index, change in fund management and operation could also affect performance.
Will TMF go up?
Looking back, the rise of TMF price at the end of 2023 could be deu to market expectations that the Fed might pause rate hikes or even start cutting rates. If the market believed that inflation pressures were easing towards the end of 2023, this could have increased demand for long-term bonds, driving prices higher, consequently boosting TMF.
Interestingly, after the rally, there was a gradual decline in early 2024, which could have resulted from a shift in market sentiment. Some investors started to believe the interest rates could remain high for longer time or the inflation could rebound, therefore they might have decided to lock in their gains, leading to selling presure on TMF and a subsequent decline in its price.
When it reached the bottom, at the same period of time, Jamie Dimon, the head of JPMorgan Chase, once warned that interest rate could even reached as high as 8% in April 2024.
Now, by August 2024, the situation shifted again as the Fed released a dovish dot plot along with more inflation and payroll data published. There was an extremely high anticipation by the market to cut rates.
In the current market (August 2024), TMF investors face several issues, particularly given the high anticipation of a rate cut in September and the recent 10% price increase in TMF.
Federal Reserve’s (Fed) rate-setting committee’s “dot plot” quarterly projection for interest rate changes suggests a 0.25% cut by December 2024.
Some say that a revised dot plot might show more aggressive cuts due to recent weakening labor market and inflation data. For example, CME Group’s FedWatch Tool suggests that futures traders are pricing in a majority chance of at least a 0.25% rate cut at each of the remaining three meetings in 2024.
However, whether Fed will cut rate as market anticipated is still not 100% sure. According to Bloomberg on August 9th 2024, a majority of economists expect the Fed to implement only a quarter-point rate cut in September, contrasting with some Wall Street calls for a larger reduction, and see little chance of an intermeeting rate adjustment.
As BofA Global Research presents, markets are pricing in 4.8 Fed cuts in 2024.
One of the biggest consideration for investors now (August 9th 2024) is the fact that the rate cut expectations is already priced in.
The recent 10% price increase in TMF, despite fluctuations, suggests that much of the market has already priced in the expected rate cut. If the Fed’s actions or guidance in September don’t meet these expectations, for example, if the rate cut is smaller than expected, delayed, of if Fed signals a less dovish outlook.
[A dovish direction means a policy stance that is more inclined toward lowering interest rates, maintaining low rates for an extended period, or implementing other monetary measures to stimulate economic growth.]
If the rates don’t drop as anticipated, or if there any adverse economic data or unexpected Fed commentary, TMF could see significant losses, potentially erasing much of its recent gains quickly.
Given the 10% price increase, there may be significant profit-taking if investors decide to lock in gains before the rate decision. This could lead to downward pressure on TMF’s price.
If the market starts to price in a steeper yield curve, where short-term rates fall but long-term rates rise due to inflation expectations or concerns about the Fed’s ability to manage inflation, TMF could also suffer. TMF benefits when long-term rates fall, so a steepening yield curve could negatively impact its performance.
Source: Fred
The effective duration of TLT is about 16.58 years now, meaning that a 1% change in rate could bring 16.58% change in TLT price.
However, if the rate has a 0.25% cut, it means TLT would grow by around 4.5%, about a quarter of 16.8%. The TMF would have around 13.5% change if it follows perfectly 3x leverage.
But as we mentioned, 10% price shows the investors have priced in. If there is only one rate cut in the coming months in 2024, it would be risky given uncertainties in rate cuts and other expense ratios in TMF investments.
If it have 0.50% rate cut in 2024, there would be some more space for growth for TMF, if all other factors are realized as investors anticipated. However, one big risk is the opportunities cost, along with other uncertainties mentioned above about the issues like macroeconomic situations, and the volatility decay.
Conclusions
TMF is primarily intended for short-term traders who want to take advantage of anticipated moves in long-term Treasury bonds.
As now the market has priced in with 10% increase in TMF value, it would be not a good option to trade this now. If the price goes down further, or there are move dovish actions by Fed, there would be space we can consider TMF.
But it should be noted that interest rate changes is not the only factor that affect TMF and TLT performance, and the implication is not always immediate.
Due to the leverage, it is not generally recommended for long-term holding as the daily rebalancing can lead to significant volatility and compounding effects that may reduce returns over time.
TMF performance is highly sensitive to changes in interest rates. When interest rates fall, the price of long-term bonds typically rise, which benefits TMF. Conversely, rising interest rates can lead to significant losses in TMF. Therefore, it is popular among investors looking to make aggressive bets on the direction of long-term interest rates and U.S. Treasury bonds.
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