An Introduction to U.S. Treasuries
Investors face many questions -- one of which is how much cash to keep on hand, and whether to keep it in currency or invest in something with a higher yield but potentially more risk. Rising interest rates at the short end of the yield curve, coupled with continuing advances in investment and index technology, may present fresh opportunities for investors seeking to maximize yield relative to risk.
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U.S. Treasury Securities
The U.S. Treasury sells debt in several forms, including Bills, Notes and Bonds. The main difference between these issues is the time to maturity when the principal is repaid. Treasuries are backed by “the full faith and credit” of the United States government, and as such are viewed by most investors as having relatively low risk.
Treasury Bills are typically sold at a discount to face value for terms ranging from four to 52 weeks, or one month to a year. The difference between the sale price and face value reflects the “interest” to be paid by the U.S. Treasury. While Notes and Bonds pay coupons, Bills do not.
Treasury Notes are securities that mature in 2 to 10 years, and Treasury Bonds mature in 20 or 30 years. Both Notes and Bonds pay interest every 6 months. In addition to the yield, or coupon, Notes and Bonds return the principal paid at the end of the term.
The Yield Curve and Fed Funds Rate
The federal funds rate is a target interest rate set by the Federal Open Market Committee (“FOMC” or just the “Fed”) which is a branch of the Federal Reserve System of the United States. This is the rate that banks charge to loan money to other banks for very short time periods, usually overnight. The federal funds rate can be viewed as a floor for interest rates. If the federal funds rate increases, that means bank must pay higher interest on when they borrow from other banks, and that gets priced into the interest rates they charge to other borrowers.
The yield curve is a graphical depiction of yields and maturities of U.S. Treasury bills, notes, and bonds, with maturities on the x-axis, and yields on the y-axis. The curve condenses a lot of information into a simple picture, as it also gives an indication of market expectations for the direction of the economy. The yield curve can take a handful of different shapes; however, it is considered ‘normal’ when yields gradually increase along with maturity, flattening out towards the later maturities. A normal curve suggests that market participants expect stable economic conditions and is the most common shape for the yield curve.
An inverted yield curve, when short term yields are greater than longer term yields, is a relatively rare occurrence, and often signals concern about the near-term economic environment. As bond prices and yields have an inverse relationship, an inverted yield curve suggests investors are moving money out of short-term instruments and into longer-term instruments. Many investors consider an inverted yield curve to be a strong signal of impending recession, but it is important to bear in mind that inverted yield curves happen rarely and as such any predictive power should be taken with a grain of salt.
Also, one should be aware that inverted yield curves don’t cause recessions. An inverted yield curve can also reflect rising inflation, as the Fed raises the federal funds rate to combat rising inflation.
Implications for Investors
While many view an inverted yield curve as a harbinger of bad times, it can present opportunities for investors.
The most obvious area of opportunity is for short-term savings. Investors looking to park cash for a few months or years can take advantage of attractive rates available from low-risk treasuries. As of March 10th, 4,6- and 12-month treasury bills are yielding more than 5%. One year ago, the same maturities offered yields of 1% or less. Investors who might have left cash to sit in a deposit account may now earn significant yields putting that cash to work – whether via ETF, mutual fund, or even buying directly.
It is important to note that even treasuries have risk, so investors should be sure to match their investment horizon to the maturity of the treasuries they purchase. By doing this, investors eliminate price risk because they will receive their principal at the end of the term, barring a default by the U.S. Treasury.
Another opportunity is less obvious, but very interesting. Many investment indexes, and the products that track them such as Exchange-Traded Funds, use short-term treasuries as cash equivalents, and the increased yield from treasuries can provide a bit of a boost to returns. For example, many indexes receive dividends intra-month, and rather than holding those dividends in cash, will invest those dividends in T-bills of maturities up to 180 days. While historically this hasn’t been terribly compelling, more recently this can provide a material boost to index returns.
Technology and Innovations
Technology spurs innovation by increasing opportunity for flexibility and automation, and the old dichotomy of active vs. passive investing no longer really holds. Technology now allows the integration of active, passive, and systematic investment approaches in a seamless fashion.
The screening, selection, weighting, and rebalancing of securities have all been automated to build and run passive, beta-focused indexes. More recently, technology has allowed index developers to use more advanced selection and weighting methodologies and enhance rebalancing schedules, generating the potential for greater efficiency and lower costs. Such strategies are often referred to as Smart or Strategic Beta and offer the opportunity to adapt more quickly to changing market environments.
The old, single dimension approach of selecting securities then weighting by market capitalization is yielding (pun intended) to more sophisticated approaches that can screen, select, and rebalance securities using information from multiple inputs and along multiple dimensions. This presents an opportunity for investors in treasuries and fixed income in terms of indexes that can adjust exposures to various maturities based on changes in yields and risks.
Conclusion
While an inverted yield curve may make investors nervous, it can also present an opportunity as higher rates on U.S. Treasuries at the short end of the curve may offer a strong alternative to holding cash. Investors should be careful to match their allocation to their investment horizon to avoid potential price risk and may want to consider implementing indexes that offer diversified or active allocations along the yield curve.
Disclaimer:
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Nasdaq Index Research Team
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