That’s all you can expect to earn over the next ten years if you invest in Ten Year US Treasury Notes. Doesn’t seem very attractive to you? You aren’t alone.
These days, investors are searching for ways to increase the yield on their portfolios. In the bond market, there are two basic ways to increase yield:
- Buy lower quality bonds (this is unpalatable to many investors)
- Buy longer maturity bonds
Today, many investors seem to choose option 2 without considering the risks or the alternatives.
First the riskâ€¦
Bond prices and yields reflect the collective thinking of all investors about the expected future of interest rates. However, the further a bond matures in the future, the more it is subject to unexpected changes in interest rates. This risk is reflected in the volatility of bond returns as maturities lengthen. In investing, the volatility of returns is called the standard deviation of returns.
Consider the chart below (click to enlarge). The chart illustrates the fact that between 1964 and 2011, 20 year treasuries were twice as risky as five year treasuries but offered a very modest .45% return advantage.
This chart clearly illustrates that buying longer term bonds to increase yield is not risk free.
Those investors interested in increasing the expected return on their portfolios may want to consider buying additional stocks in their portfolios rather than buying longer-term bonds.
Why? Lets look at the numbers. Using a simple example, investors could make an investment in the S&P 500 (a broad index of US companies) and earn a yield of more than 2% in the form of dividends. So their immediate cash flow is greater than the investment in ten-year treasuries and they may benefit from dividend and earnings increases over the next ten years.
Clearly, this strategy is not risk free either. However, for those investors with the right risk tolerance and time horizon, it looks like an attractive alternative to buying longer term bonds.