Very few people want to talk about fixed income. It is all about stocks, stocks, stocks. Headlines love to reference the S&P 500, the NASDAQ, or the DOW. When bonds are the topic, the article is rarely as captivating as reading about new highs in an equity index. This article focuses on the least exciting investment position that no one really talks about. US Treasuries deserve their time in the sun.
Don’t get us wrong though, we understand that it has been painful to hold US Treasuries during the bull market of the past decade. The yield on the 10-year Treasury is at historically low levels, continuing a downward trend that started in the early 1990s. At this point, the yield produced by a 10-year Treasury is comparable to the dividend yield of a total domestic equity ETF (and is taxed less favorably to boot) [1]. And the performance?!? In the 10-year period starting on January 1st, 2010, the iShares 7-10 Year Treasury ETF has returned 4.41% (total return annualized). Meanwhile the Vanguard Total Stock Market ETF has averaged 13.35% per year (over three times greater over the same period).
So why continue to buy and hold US Treasuries? For exactly the same reasons listed above. Being properly diversified requires the portfolio to hold positions that react differently to the same event. The cost of diversification may require that you hold a position that you just, well frankly, don’t like. When you are in love with equity, it is likely you will loathe your fixed income.
Yields are down for US Treasuries, but yields are down for basically all bonds. Seeking a higher yield means seeking a riskier bond (more credit risk equals more return). But, as investors search for more yield, they begin to buy bonds that act like equity. Diversification is often the first sacrifice made in the pursuit of returns.
The graph below shows the total return for four different positions for the rolling 10-year period beginning on 1/1/2010: A total equity market ETF (blue), an intermediate-term corporate bond fund (red), a high-yield corporate bond fund (purple), and a 7-10 year Treasury bond fund (green) [2]. Hard to stand up for a Treasury bond fund when it has been lagging corporate bonds, high-yield, and certainly equities for the past 10 years.
Returns 1/1/2010 - 1/1/2020
However, risk can be most present when you feel it the least. As the world markets plunged into economic uncertainty as a result of the COVID-19 pandemic, so too did the equity prices. Just as investors doubted the health of the individual stock, they doubted the health of the individual corporate bond. Higher yielding bonds revealed the true nature of higher credit risk, a correlated drop with equity in times of market turmoil. Here is the same graph for 2020 year-to-date:
Returns 1/1/2020 - 6/1/2020
Treasury bond prices appreciated as a result of investors “flight to quality” or “flee to safety”. Treasury bonds have virtually no credit risk and are considered the safest investment in the world (the United States has never defaulted or missed a payment on a debt). US Treasuries are a direct beneficiary of the Fed cutting interest rates and as investors ran from risk and arrived at safety, they drove the price of the US Treasury bonds up.
Thus far in 2020, the 7-10 year Treasury bond ETF has returned 9.96% compared to the total domestic equity market falling 9.18%. A portfolio holding 50% 7-10 year Treasuries and 45% equities is actually up 0.37% year-to-date [3]. If that portfolio were holding intermediate-term corporate bonds, it would be down 4.47% (requiring a 4.67% positive return to break-even) [4].
We often refer to US Treasuries as the buoy that helps your portfolio stay level in times of market turbulence. This buoy may feel like an anchor when equities are rising, but it can also keep you afloat when equities retreat. The costs of diversification can appear unbearable when looked at through the lens of short time periods. However, through time and the inevitable bear markets that we are destined to experience again and again, the costs of diversification are quickly justified.
[1]: Comparing the distribution yield of total equity market ETF (VTI) to the distribution yield of 7-10 year Treasury bond ETF (IEF).
[2]: Total equity market ETF (ticker: VTI); Intermediate-term corporate bond fund (ticker: VCIT); high-yield corporate bond fund (ticker: VWEHX); 7-10 year Treasury bond fund (ticker: IEF).
[3]: 39% total equity market ETF (VTI), 6% FTSE all-world ex-US ETF (VEU), 50% 7-10 year US Treasury bond ETF (IEF), 5% Cash.
[4]: 39% total equity market ETF (VTI), 6% FTSE all-world ex-US ETF (VEU), 50% intermediate corporate bond fund (VCIT), 5% Cash.