Treasury bonds correlate less with stocks than do corporate bonds, making treasuries an ideal portfolio ballast. Specifically, intermediate-term treasuries provide the highest yield for the least volatility. The Vanguard Intermediate-Term Treasury Fund is the best bond fund for most portfolios.
What is a Bond?
A bond is a loan to a government or corporation in exchange for their promise to pay periodic interest payments until repayment of the loan upon the bond’s maturity date.
Not all bonds are created equal. Bonds are subject to a set of risks for which investors demand higher interest payments for taking on.
What is Credit Risk?
The most fundamental of these risks is “credit risk” or the likelihood that the government or corporation will default on interest payments or not repay your loan.
Bonds issued by the U.S. Treasury are backed by the full faith and credit of the U.S. government and therefore considered to have no credit risk. Bonds issued by corporations are riskier because corporations are subject to experiencing financial difficulties or declaring bankruptcy.
Since credit risk is felt when companies experience financial trouble, corporate bonds tend to correlate more strongly to stocks than treasury bonds do. Treasury bonds tend to negatively correlate with stocks, making them ideal for softening the volatility of stocks and providing you more assets during stock market downswings to sell and buy the now cheap stocks.1,2
What is Interest Rate Risk?
U.S. Treasury bonds come in three major asset classes:
- Short-term (bonds maturing in less than 3 years often called treasury bills)
- Intermediate-term (bonds maturing in 3-10 years often called treasury notes)
- Long-term (bonds maturing in 10-30 years often called treasury bonds)
The longer the bond term, the greater the “interest rate risk,” which is the risk that the Fed will increase interest rates. When interest rates are increased, any newly issued bonds promising higher periodic interest payments become more attractive and worth more to investors than any already existing bonds promising comparatively lower periodic interest payments.
If interest rates rise, investors already in short-term bonds have few low-interest payments remaining before their loan is repaid and they can soon use that repayment to buy the more attractive high-interest bonds. Investors already in long-term bonds will have many low-interest payments remaining before they can do the same.
If owners of long-term bonds want to sell their bond after interest rates rise, they will need to sell it for less than they bought it for to compensate the buyer for taking on a bond with lower interest payments than new bonds are offering. To compensate investors for taking on interest rate risk, long-term bonds come with higher interest payments.
Yield Curve: The Problem with Long-Term Bonds
The problem with long-term bonds is that their interest rate risk subjects them to greater volatility, which is exactly what you were looking to avoid by investing in bonds in the first place.
Michael Kitces, Director of Wealth Management at Pinnacle Advisory Group, showed that during times of falling interest rates equity/bond portfolios with long-term treasury bonds had the highest safe withdrawal rate in retirement and during times of rising interest rates equity/bond portfolios with short-term treasury bonds had the highest safe withdrawal rate in retirement.3
Since future interest rates are not very predictable, Kitces favors avoiding long-term bonds because in the worst-case (lowest safe withdrawal rate) scenario, short-term treasury bonds had a higher safe withdrawal rate than long-term treasury bonds.
Part of the problem with long-term treasury bonds is that interest rates taper off as maturity lengths increase, making a curve known as the “yield curve.” That is, as you take on more and more interest risk, you get less and less interest yield in return.
As you can see, the yield curve is almost a straight line for the first 5 years, tapers off in years 6-10, and and begins to flatten out in years 11-30.4 This yield curve makes bonds that mature right around the 5-year mark, typically held by intermediate-term funds, the sweet spot of getting the most yield for the least risk according to notable financial theorist William Bernstein.5
You Don’t Need to Diversify Treasury Bonds
Unlike stocks, treasury bonds do not benefit from diversification. Whereas stocks (and corporate bonds for that matter) comprise of unsystematic risk, which is risk that can be diversified away, treasury bonds comprise of systematic risk, which cannot be diversified away.
Larry Swedroe, in his book “The Only Winning Bond Strategy You’ll Ever Need” demonstrates the concept using a farmer and his crops.6 A farmer cannot diversify away the risk that flood, drought, insects, plague, or other adverse events might destroy his crops (systematic risk), but he can diversify away the risk that his returns are diminished due to falling soybean crops by also planting corn, wheat, and sorghum (unsystematic risk).
Since treasuries only comprise of interest rate risk that cannot be diversified away, we will likely do best to pick the treasury term most suited for our investment style which is whatever term provides the best combination of the highest yield, the least volatility, and the least correlation with stocks.
Negative Correlation of Bonds to Stocks
We already covered how intermediate-term treasury funds provide the highest yield for the least volatility, but how do they stack up against short-term and long-term treasury funds when it comes to having a low correlation with stocks?
Over the 35 years prior to 2015, intermediate treasuries have tended to provide the best combination of being negatively correlated with stocks (-1 correlation is best) and low-volatility (0 beta is best) as shown in the graphic below, making intermediate-term treasury bonds the bond class of choice.
What about municipal bonds and high grade corporate bonds which are in the vicinity of low correlation to stocks and low volatility?
Municipal bonds tend to return a higher yield than treasuries after taxes as they are exempt from taxes, but less than treasuries before taxes. Since bonds should be kept in tax advantaged accounts when possible to ensure tax efficient placement, we can take advantage of the higher return of intermediate-term treasury bonds without worrying about the tax implications.
High grade corporate bonds tend to return a slightly higher yield than treasury bonds, but as they are subject to credit risk they don’t protect us from recessions. As Bernstein put it “In a normal bear market, high-quality corporate bonds should do OK, but in a deep financial crisis, they won’t.”7
What About TIPS?
In 1997 the U.S. Treasury started offering Treasury Inflation Protected Securities (TIPS). TIPS are treasury bonds that hedge against inflation based on the Consumer Price Index such that when inflation is higher than expected the value of TIPS goes up and when inflation is lower than expected the value of TIPS goes down.
This makes TIPS safer over the long run than the “nominal” bonds discussed previously, but TIPS can be riskier over the short term.
When the market crashes it also experiences deflation which is bad for TIPS. This is exactly what happened during the great recession at the end of 2008. The average TIPS fund lost 4% even as the Barclays U.S. Aggregate Bond Index, which excludes TIPS but includes significant exposure to treasuries, gained more than 5%.8 This makes TIPS not as good as nominal bonds for diversifying against stocks.
And The Winner Is…
Vanguard’s Intermediate-Term Treasury Fund (VSIGX for ultra-low-fee admiral fund or VFITX for low-fee investor’s fund).
Investors who need to invest in bonds in taxable accounts should use Vanguard’s Intermediate-Term Tax-Exempt Fund (VMLUX for ultra-low-fee admiral fund or VMLTX for low-fee investor’s fund) comprised of mostly municipal bonds. If you live in California, Massachusetts, New Jersey, New York, Ohio, or Pennsylvania there are alternative Vanguard funds you should use in taxable accounts to exempt earnings from state income taxes.
If you need to expand past a Vanguard IRA to house your appropriate bond allocation and your 401(k) doesn’t offer an intermediate-term treasury nominal bond fund with an expense ratio that is at least within 0.1% of the cheapest bond fund offered, you should favor the cheaper bond fund. Usually the lowest fee bond fund will reflect domestic bonds.
If you do venture into international bond funds you need to make sure they are currency hedged, which means they are immune to currency volatility. Otherwise, currency volatility can erase the portfolio steadiness you are trying to gain with bonds. Currency hedging comes with a fee and tends to make international bond funds more expensive than domestic bond funds, rendering international bond funds unnecessary for your portfolio.