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Capture Yields as High as
10.5% with Safe Treasury Funds |
Published:
March 17, 2008
Nervous investors are spouting a lot of four-letter words at the
market these days -- and one of them is "SAFE." And you would be
hard-pressed to find any safer payouts than those offered by U.S.
Treasuries. Amid gut-wrenching volatility in the stock market
and a slowing economy, investors are fleeing to the safety of
these risk-free government bonds.
Ultra-safe Treasuries trounced the S&P 500 last year for the
first time in five years. The iShares Lehman 7-10 Year Treasury
exchange-traded fund (NYSE: IEF), which tracks U.S. Treasuries,
returned a hefty +10.4%, nearly double the S&P 500's total
return of +5.5%. Inflation-linked government bonds have done
even better -- with the iShares Lehman TIPS ETF (NYSE: TIP)
returning +11.9% for the year.
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The Problem of Popularity
The problem is that as Treasury prices rally, their yields fall,
and the latest surge has brought Treasury yields to their lowest
levels in roughly four years. From a high of 5.32% last June,
the 10-year Treasury yield has shed about a third of its value.
Why, then, would income investors want to pour their money into
securities yielding just 3% or 4%?
The answer to that question is simple: you don't need to invest
directly in Treasuries to gain a high degree of safety. Funds
that hold a diverse basket of government bonds can do the heavy
lifting for you while offering yields well above Treasuries.
There are dozens of funds that focus on U.S. government bonds -- and
new ones are continually coming to market.
Picking a Winner
As we said earlier, investing in government Treasuries is very
safe -- the bonds are considered credit risk-free, in that
interest and principal payments are backed by the full faith and
credit of the U.S. government. Like most bonds, however, the
value of government-backed bonds rises and falls with
changes in interest rates.
When a bond is issued, it pays a fixed rate of interest,
called a "coupon
rate." For example, let's say you buy a 10-year Treasury
worth $1,000 that carries a 4% coupon rate. If you hold it until
it matures, you can expect to receive $40 a year in interest and
get back your $1,000 in 2018.
If you sell the bond before it matures, however, the value of
the bond will typically reflect changing interest rates. If
interest rates on 10-year Treasuries were to rise next year to
5%, the bond you bought for $1,000 might sell for just $800,
since an investor can earn more interest by buying a new bond at
a higher coupon rate. At $800, the $40 in annual interest gives
the bond a yield of 5% ($40/$800 = 5%). But if 10-year Treasury
yields fell to 3%, your bond could increase in value to $1,333
to give it a yield equivalent to new Treasuries ($40/$1333 = 3%).
Investors should also note a bond's "duration"
Duration is a complex calculation expressed in years that
measures how volatile a bond can be as interest rates rise and
fall. Simply put, if interest rates rise +1%, the price of a
bond with a duration of five years is expected to fall by around
-5%, but a bond with a longer duration of ten years could lose
some -10% of its value.
As you can see, funds holding bonds with longer durations
(typically more than five years) may suffer greater losses when
interest rates rise. But if rates fall, they could enjoy
stronger returns since longer-duration bonds should rise faster
than comparable bonds with shorter durations.
Like any metric, duration isn't foolproof. For example,
inflation fears can hurt long-term bond prices even when
interest rates are falling, but have less affect on shorter-term
bonds. In addition, factors such as leverage, derivatives, or credit
quality can make a fund more volatile than its duration would
predict. As a rule of thumb, though, a long-term bond fund with
a duration of ten years would be about twice as volatile to
changes in interest rates as a fund with an average duration of
five years. As such, shorter-duration funds are more appealing
to long-term income investors since their returns tend to be
more stable.
Many Fish in the Sea
Luckily for us, bond funds with exposure to safe U.S. Treasuries
are plentiful. And best of all, many funds spread their assets
out among a vast array of bonds in order to increase yields. The
list of funds below provides a great starting point for
potential bond fund investors -- including some funds that yield
up to 10.5%. . .
Important Note: In the
remainder of this article,
High-Yield Investing editor Carla Pasternak provides
a detailed listing of 12 Treasury bond funds with varying durations and
yields as high as 10.5%. Additionally, she profiles two specific
funds that she thinks will outperform the market in the coming
months. However, in order to view the remainder of this
article, you'll need to subscribe to our premium income-investing
newsletter --
High-Yield Investing. After you subscribe, you'll
receive immediate access to this full article, as well as our
monthly
High-Yield Investing newsletter and a host of
additional premium content. Please visit one of the following
links to continue.
Good investing!
Carla Pasternak
Editor
High-Yield Investing
http://www.StreetAuthority.com
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