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Fly to Quality with U.S.
Treasury Funds |
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Published:
March 31, 2008
When gut-wrenching volatility hits
the market and the economic outlook
is negative, nervous investors look
for safe, dependable investments. And you would be
hard-pressed to find any safer payouts than those offered by U.S.
Treasuries. Treasury bonds are considered credit risk-free, in
that interest and principal payments
are backed by the full faith and
credit of the U.S. government.
But this safety doesn't come at the
expense of returns, particularly
when the markets are in a rut.
Treasuries trounced the S&P 500 in
2007 for the
first time in five years. Many
exchange-traded treasury funds more than doubled the S&P 500's total
returns of +5.5%.
Picking a Winner
When a bond is issued, it pays a fixed rate of interest,
called a "coupon
rate." For example, let's say you buy a 10-year Treasury
worth $1,000 that carries a 4% coupon rate. If you hold it until
it matures, you can expect to receive $40 a year in interest and
get back your $1,000 in 2018.
If you sell the bond before it matures, however, the value of
the bond will typically reflect changing interest rates. If
interest rates on 10-year Treasuries were to rise next year to
5%, the bond you bought for $1,000 might sell for just $800,
since an investor can earn more interest by buying a new bond at
a higher coupon rate. At $800, the $40 in annual interest gives
the bond a yield of 5% ($40/$800=5%). But if 10-year Treasury
yields fell to 3%, your bond could increase in value to $1,333
to give it a yield equivalent to new Treasuries ($40/$1333=3%).
Investors should note a bond's "duration."
Duration is a complex calculation expressed in years that
measures how volatile a bond can be as interest rates rise and
fall. Simply put, if interest rates rise +1%, the price of a
bond with a duration of five years is expected to fall by around
-5%, but a bond with a longer duration of ten years could lose
some -10% of its value.
As you can see, funds holding bonds with a longer duration
(typically more than five years) may suffer greater losses when
interest rates rise. But if rates fall, they could enjoy
stronger returns since longer-duration bonds should rise faster
than comparable bonds with shorter durations.
Like any metric, duration isn't foolproof. For example,
inflation fears can hurt long-term bond prices even when
interest rates are falling, but have less affect on shorter-term
bonds. In addition, factors such as leverage, derivatives, or credit
quality can make a fund more volatile than its duration would
predict. As a rule of thumb though, a long-term bond fund with
a duration of ten years would be about twice as volatile to
changes in interest rates as a fund with an average duration of
five years. As such, shorter-duration funds are more appealing
to long-term income investors since their returns tend to be
more stable.
Protect Your Portfolio
Inflation is the bogeyman of the bond investor, and it can
cut into the value of your bond holdings. A +5% rise in
inflation will throw
your 4% bond into negative returns and will send its price into a
tailspin.
Inflation is a potential threat that
arises during low interest rate
environment. The problem is that
lower interest rates can make the
U.S. dollar less attractive to
foreign investors, causing it to
weaken against other currencies and
make goods from other countries
costlier.
What's an income investor to do?
Enter: Treasury Inflation-Protected Securities (TIPS) and the
funds that hold them. TIPS are linked to the Consumer Price
Index, so their value increases as consumer prices, including
food and energy, rise.
For instance, say you buy a 10-year, $1,000 TIPS bond in March. If by
June inflation rises +1%, your bond principal would now be
$1,010 (1.01 * $1,000). If you hold the bond until it matures in
2018, you will receive either the inflation-adjusted principal
or the original $1,000, whichever is higher (if there is
deflation, the principal won't fall below its $1,000 par value).
The bond's interest payments also rise with inflation, as they
are calculated at a fixed rate on the inflation-adjusted
principal.
Taxes
Interest income on Treasury bonds,
including TIPS, is taxable as
ordinary income at the federal
level, but is not taxed on the state
and local levels. As such, bonds and
bond funds are best held in a
tax-deferred IRA or 401(k) account.
Headwinds
Treasuries and TIPS can be shining
stars against a backdrop of doom and
gloom in the financial markets. When
stocks rally, Treasuries lose some
of their luster as investors rotate
out of safety in search of growth
potential. Still, with their
risk-free payouts, Treasuries and
the funds that hold them should
provide a solid addition to any
income portfolio.
With this in mind,
High-Yield Investing editor Carla Pasternak
covered Treasury funds in a recent
issue of her monthly newsletter. She provided
a detailed listing of 12 Treasury bond funds with varying durations and
yields as high as 10.5%. Additionally, she profiled two specific
funds that she thinks will outperform the market in the coming
months.
To learn the name of these
securities, we invite you to try a
no-risk subscription to
High-Yield Investing. To learn
more, please
visit this link. |
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