As the financial crisis unfolded in 2008 and the first part of 2009, many investors exited the equity markets and fled to the safety of U.S. Treasury bonds. The rationale behind this move was simple: In anticipation of further declines in equities, these investors were seeking to eliminate stock market risk and preserve their remaining assets in a very safe investment. Some were enticed by the returns of 20% or more that long-term U.S. Treasuries generated in 2008. However, as the table below illustrates, “risk free” investments in long-term U.S. Treasuries have been disappointing this year:
Year-to-Date Performance through 5/31/09:
Barclays 7-10 Year U.S. Treasury Index: -6.1%
Barclays 10-20 Year U.S. Treasury Index: -9.1%
Barclays 20+ Year U.S. Treasury Index: -20.2%
Barclays 1-3 Year Corporate Bond Index: +5.2%
Global Equities (MSCI AC World Index): +10.2%
Investors who exited the stock market and purchased long-term Treasuries were not actually eliminating risk – they were exchanging one form of risk for another. While equities involve market risk (the risk that the stock market will decline), Treasury bonds involve term risk (the risk that an increase in interest rates will cause a decline in bond prices). As confidence has returned to the markets and interest rates have risen, this term risk has manifested itself in dramatic fashion. Investors holding these longer-term Treasuries are now faced with an unsavory choice: They can either sell their positions and realize a significant loss of principal, or they can hold the bonds to maturity and lock-in a paltry interest rate during a period when inflation will likely be on the rise.
While long-term Treasuries have suffered this year, many other fixed income asset classes have performed very well. Investors holding short-term investment grade corporate bonds have seen their fixed income portfolios flourish in 2009. As of 5/31/09, the Barclays 1-3 Year Corporate Bond Index has returned over 5%, a significant outperformance of the Treasury market. This year is a prime example of why Heritage advocates using short-term bonds; the additional returns offered by longer-term bonds do not adequately compensate investors for the significant price risk that they entail.
More than anything, this illustration teaches us yet again that there is no free lunch. The only truly risk-free investment is cash, which is currently generating a guaranteed return of less than 0.5%. Equities offer higher returns than cash because they involve the risk of loss. Longer-term Treasury bonds offer higher returns than cash for the same reason.
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