Should You Add Treasury Bonds to Your Portfolio?

brianoconnell

Treasury bonds can play a critical role in personal money management, especially for American either heading into retirement or already established in their golden years.

Treasury bonds, a key component of the fixed-income investments family, appeal to investors seeking capital preservation, i.e., making sure they don’t lose any money from investment assets they’ve accumulated over a lifetime of saving.

That’s the direct opposite of capital appreciation, which is the process of accumulating portfolio assets, mostly through investments (like in 401k or IRA plans, or through standalone investment portfolios) made in one’s working years.

The Kitchen Table Economist asked Robert R. Johnson, Professor of Finance, Heider College of Business, Creighton University, for his definition of Treasury bonds, and how they may fit into your investment portfolio.

Here's what he had to say.

KTE: What are Treasury bonds?

Johnson: Treasury bonds are simply the debt of the US government and are considered default-free instruments because they are backed by the full faith and credit of the US government. If one buys a Treasury bond and holds it to maturity, the investor knows exactly the return they will receive.

Technically, the government only issues Treasury bonds in 30-year maturities.. But, it issues Treasury notes in maturities range as short as two years and no longer than 10 years. Treasury notes and Treasury bonds are essentially the same type of instrument and only differ in original maturities. Purchasers of Treasury bonds and notes receive an interest payment every six months.

Treasury bills (T-bills) are the short-term debt of the government. They are issued with original maturities of four, eight, 13, 26, and 52 weeks. They don’t pay interest and are issued on a discount basis.

That is, the investor receives a higher amount when the bill matures than they paid to acquire it.

KTE: What are the big benefits with Treasury bonds?

Johnson: Treasury bonds have many advantages and one of the chief advantages is high liquidity. There are many buyers and sellers in the Treasury bond markets so the bid-ask spread (the difference between the offering price to sell and offering price to buy) is extremely narrow.

While Treasury bonds and notes are default risk-free and one can essentially lock in a rate of return by buying a treasury bond or note and holding it to maturity, they are not risk-free. Treasuries have price risk. If an investor buys a treasury bond and interest rates in the market subsequently go up, the price of that Treasury bond or note will fall.

That’s because newly issued treasuries will carry a higher interest rate. So, all else being equal, longer term bonds have more price risk than shorter term bonds. That is, if interest rates in the market rise, the value of all existing bonds will fall, but the value of long-term bonds will fall more than the value of shorter-term bonds.



KTE: Can you walk us through the yield curve?

Johnson: The US Treasury yield curve is simply a graph showing the relationship between the yield (rate of return) on a US Treasury in relation to the maturity of the instrument. Most often, the yield curve is upward sloping.

In other words, longer-maturity Treasury bonds have a higher yield to maturity than shorter term Treasury bonds. This makes intuitive sense: A longer time period generally has greater risks, just because there’s more time for unexpected things to happen.

Most lenders prefer to lend short term, and most borrowers prefer to borrow long term. To induce lenders to lend long term, lenders must be offered s time premium.

Sometimes, however, the yield curve can become flat or even inverted. A flat yield curve is one in which all yields are very close to one another. An inverted yield curve happens when shorter term yields are actually higher than longer term yields.

Many people believe that a flat or inverted yield curve is a precursor to an economic recession or slowdown. Lenders are willing to accept a lower long term yield to lock in the current returns, while borrowers are willing to pay higher rates in the short term because they believe they’ll be able to get more favorable long term rates in the future.

KTE: How do Treasury bonds measure up, performance-wise?

Johnson: Whatever the maturity, over the long-term, investors in Treasuries (intermediate term and long-term) earn lower returns than those investing in stocks and corporate bonds.

According to data compiled by Ibbotson Associates, large capitalization stocks (think S&P 500) returned 10.0% annually from 1926-2018. Over that same time period long-term corporate bonds returned 5.9%, long-term government bonds returned 5.5% annually, intermediate term government bonds returned 5.1% annually and T-bills returned 3.3% annually.

The surest way for investors with a very long term time horizon is to invest in a diversified stock portfolio.