Consider Alternatives to So-Called 'Risk-Free' Treasuries

US News

The words "Treasury bond fund" typically evoke thoughts of safety, stability and risk-free returns. As interest rates in the U.S. has trended lower and bond prices trended higher over the past 30 years, you may also be thinking of capital appreciation. After new developments this year, however, you may want to rethink some or all of these long-accepted notions.

The yield on the 10-year Treasury note has risen sharply throughout the year, from 1.75 percent at the start of the year to 2.9 percent today. As bond prices and yields are inversely related, this spike in yields has caused a significant decline in Treasury prices, particularly at the longer end of the curve. With this decline in price, volatility within the bond market has increased significantly.

For example, the standard deviation, which is a common measure of volatility, has actually been higher in the long-duration U.S. Treasury ETF than in U.S. equities. The maximum drawdown for the U.S. Treasury exchange-traded fund, at a decline of 17.2 percent, is more than double the maximum drawdown in U.S. equities, at a decline of 7.4 percent.

The message is clear: For most of 2013, bonds have actually been a riskier investment than stocks. What's worse is that long-duration bonds tend to do well during stock market corrections, and that was not the case this year. In the only Standard & Poor's 500 index correction of greater than 5 percent, which occurred from May through June of this year, the U.S. Treasury ETF actually declined more than the S&P 500.

That said, 2013 has certainly been an outlier year for U.S. equities, and we should not expect a repeat in 2014 in terms of bonds showing higher volatility than stocks. However, the broader implications still stand. If the spike in interest rates this year is indicative of an end to the 30-year-old secular bull market in bonds, investors should be prepared for meaningfully lower returns and higher volatility in bonds going forward.

This is not to say that bonds serve no purpose in a diversified portfolio today. But investors need to understand that the tailwind (falling interest rates) that has persisted for much of the past 30 years is now a clear headwind (rising interest rates). As such, expectations need to be lowered and investors will have to look elsewhere if they want to achieve the returns they had been counting on from bonds.

The dilemma is that they are likely to incur higher volatility in order to do so.

First, they can stay within fixed income and move up the risk spectrum to investment-grade corporates, bank loans, and high-yield bonds. This year, this shift would have served investors well, as these investments, especially on the riskier end of the spectrum, handily outperformed long-duration bonds.

With an effective duration of under five years, both high-yield bonds and bank loans are significantly less sensitive to a rise in interest rates than the long-duration Treasury ETF with an effective duration of over 16 years. Duration is the approximate percentage change in price for a 100 basis point change in interest rates. Therefore, if interest rates increase by 100 basis points, we can expect the U.S. Treasury ETF to decline over 16 percent versus a decline of less than 5 percent for high yield bonds and bank loans.

Bank loans have an added benefit in that they are floating-rate and pay a coupon based on a fixed spread above short-term Libor rates. When Libor increases in the future (as it will when the Federal Reserve finally raises the federal funds rate) the yield on bank loans will increase as well.

Other options that can provide income include convertible bonds, real estate investment trusts, master limited partnerships, preferred stocks, utilities and other high-dividend equities. As competing instruments to bonds, they are not immune from a rise in rates but they can offer the potential for capital appreciation as well as income.

Of course, there is no free lunch with these alternatives to bonds. Although they are less sensitive to interest rate risk, they are more sensitive to credit risk and equity market risk. U.S. high-dividend equities have done extremely well this year (up over 26 percent) given the rise in the S&P 500 this year, but that shouldn't fool investors into believing they are anything close to risk-free. During the last bear market, beginning in 2007 and ending in 2009, U.S. high-dividend equities declined over 63 percent from high to low.

Overall, given the historically low yields on Treasury bond funds and likelihood that the 30-year decline in interest has ended, investors need to rethink their bond allocation in terms of expected returns and volatility. If investors hope to achieve a similar rate of return as in the past, they will have to consider some of these alternatives. However, there are trade-offs, and with these alternatives comes increased risk and volatility. Investors should understand these risks and become comfortable with that trade-off before making any major asset allocation decisions.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

Michael A. Gayed, CFA, is a chief investment strategist and co-portfolio manager at Pension Partners, LLC., an investment advisor which manages a mutual fund and separate accounts according to its ATAC (Accelerated Time and Capital) strategies focused on inflation rotation. In 2007, he launched his own long/short hedge fund, using various trading strategies focused on taking advantage of stock market anomalies. Follow him on Twitter @pensionpartners and YouTube.

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