Over the last seven years, bond yields have drifted downward and stayed low, with all-time lows bottoming in July 2012. Low rates are in part attributable to the Federal Reserve artificially applying pressure as a part of Quantitative Easing. Despite a rise in rates last summer, yields are still near historic lows. As a result of low yields, investors have been forced out of “safer” assets (e.g., investment grade bonds) and into “riskier” assets (e.g., high yield bonds and stocks) in search of higher returns.
Yet, there is still a case to be made that safer, lower-yielding assets, such as U.S. Treasuries remain attractive investments and can provide for a sufficient return without excess risk. This can be especially true when an investor utilizes closed-end funds for their U.S. Treasury exposure.
When individuals think of bonds, the first thing that comes to mind is the coupon rate. Even though the coupon rate is a source of return, multiple studies have shown that the majority of investment return for bonds comes from price appreciation as a result of changes in interest rate levels. This is particularly true for U.S. Treasuries.
To understand how a bond’s price adjusts to changes in interest rates, one must understand duration. Duration is a measure of the sensitivity of the bonds price to the change in interest rates. For example, assume a bond has a current price of $100, a duration of 5 and interest rates are currently 3.4 percent. If interest rates move down 1 percent (to 2.4 percent), the price of the bond price should move up roughly 5 percent – or a new price of $105. In contrast, if interest rates moved up from 3.4 percent to 4.4 percent the price would move down roughly 5 percent, or from $100 to $95. These prices adjust so the bond that the investor bought with a yield of 3.4 percent is yielding the same as the current interest rate levels after the rates moved.
An investor might ask the question “why would somebody want to buy a bond that is only yielding 2.4 percent when the stock market returned 32 percent last year?” Aside from the benefits of asset diversification, another reason to own a 10-year U.S. Treasury is that interest rates could still continue to move down. To find evidence to support this idea, it is important to look at the global bond market. If you look at what other countries’ 10-year bonds are yielding, you will see that several countries have yields significantly below ours. For example, the German 10-year bond is yielding less than one percent, France’s 10-year bond is below 1.5 percent, and Spain’s 10-year bond, which was facing fears of default in 2012, is currently yielding less than the U.S. 10-year Treasury bond. With these options in the investment landscape the 10-year U.S. Treasury is an attractive investment opportunity.
Arguably, one of the best ways to purchase U.S. Treasuries is though the closed-end fund format. Instead of buying a handful of individual bonds, investors benefit from lower transaction costs, professional management, and diversification. What more, closed-end fund investors can often buy $1 worth of assets for $0.85 to $0.90, which results in an increased yield. For example, assuming a portfolio has a yield of 2.5 percent and the closed-end fund was bought at a 12 percent discount, the effective yield is now 2.85 percent. Put another way, the investor in our example would be paying $0.88 for a 2.5 percent yield, instead of paying $1.
If you think that you would like to take advantage of the value of U.S. Treasuries by investing in closed-end funds, contact your financial professional for more information.
Byron S. Sass is a fixed income analyst/account manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, NY 14534; phone (585) 586-4680.