Ten-year Treasury notes may not be giving you enough comparative diversification benefits to justify their potential downside risk. Though long-term Treasuries (NYSE:TLT) have historically had low correlation coefficients with large-cap stocks, intermediate-term Treasuries are even less correlated with large-cap stocks (NYSE:SPY).
I want to clearly state that is not an argument against holding Treasuries, even though yields on the benchmark 10-year note fell below 3% on Wednesday. Rather, it is about finding a proper balance between risk and reward.
Bonds are a form of a loan. The most common types of bonds pay a set percentage of interest over a specified period of time, referred to as the coupon rate. At maturity, the face, “par,” value of the bond is returned. Since the coupon rate does not change, bonds with longer maturities are more sensitive to interest rate changes than those with shorter maturities. All things being equal, an investor would rather not hold a bond with a low coupon rate when new bonds are being issued at higher coupon rates. This is why bond prices fall when interest rates rise, and why bond prices rise when interest rates fall.
You can see this relationship by watching changes in yield. Yield factors in both the interest rate paid by the bond and the actual price of the bond. It is a measure of the total cash flows you will receive by holding the bond to maturity.
In an environment where interest rates are projected to stay stable or fall over the next several years, long-term bonds have an appeal. An investor can lock in a comparatively good interest rate now. Unfortunately, given that yields on the 10-year Treasury note fell below 3% yesterday and the latest issuance of the benchmark note had a coupon that was not much higher, history suggests rates are likely to rise in the future. (The consensus view also calls for higher interest rates; when rates will actually rise and by how much are the big unknowns.)
In such an environment, the allocation benefit of long-term Treasuries (NYSE:TLT) may not be comparatively beneficial. According to the Ibbotson SBBI 2011 Yearbook, long-term Treasuries have a correlation coefficient of 0.11 to large-cap stocks. This means that long-term Treasuries have very different return characteristics than the S&P 500 (NYSE:SPY); not opposite, but different. (The closer a correlation coefficient gets to zero, the greater the diversification benefit. A correlation coefficient of +1.0 means returns should move in lockstep, whereas a correlation coefficient of -1.0 means returns are mirror opposites.)
Combining long-term Treasuries (NYSE:TLT) with large-cap stocks (NYSE:SPY) does provide diversification benefits. However, intermediate-term Treasuries have a correlation coefficient of 0.08. In other words, they are less correlated to large-cap stocks than long-term Treasuries are. This means you can get improved diversification with less interest rate risk. (In case you’re wondering, long-term corporate bonds have a correlation of 0.23 with large-cap stocks. The Ibbotson SBBI Yearbook uses a 20-year maturity for calculating long-term Treasury and corporate bond returns and a five-year maturity for intermediate-term Treasury returns.)
Diversification is just one consideration, however. Bonds do provide regular income and, depending on your needs, holding a longer-term bond may still make a lot of sense. You should consider the coupon rate paid by your bond, which may be higher than the yields currently quoted for Treasuries. Furthermore, bonds give you a return of investment, whereas stocks merely provide a return on investment. Finally, you can offset the interest rate risk by combining short-term bonds with your long-term bond holdings (a strategy referred to as a creating a “barbell”). If you own bond funds, you can either opt for funds with shorter durations or create a fund barbell by mixing long-term and short-term bond funds.
Charles Rotblut is the author of the new book Better Good than Lucky: How Savvy Investors Create Fortune with the Risk-Reward Ratio. The AAII Sentiment Survey has been conducted weekly since July 1987 and asks AAII members whether they think stock prices will rise, remain essentially flat, or fall over the next six months. The survey period runs from Thursday (12:01 a.m.) to Wednesday (11:59 p.m.). The survey and its results are available online at http://www.aaii.com/sentimentsurvey