Mario Iacone: Treasury Bonds Provide True Diversification in Asset Allocation (corrected)

From Mario Iacone, October 2, 2009

TREASURY BONDS PROVIDE TRUE DIVERSIFICATION

IN

ASSET ALLOCATION

This is a correction to my previous post resulting from reader feedback. The information corrected is in italics near the bottom.

The following has been written in response to the questions and comments I have received due to promoting a larger percentage of Treasury Bonds in the STRS asset allocation. It has been overly simplified to provide a basic understanding for those that have none.

Be aware that using Treasury Bonds as diversification in a portfolio requires substantial effort, especially if traded short term on the secondary markets, and becomes substantially more complex than described below. While reading the following, please keep in mind that supply and demand also effect the price fluctuation on the secondary market.

Most inexperienced investors know that the purchase of a Treasury Bond will pay the indicated interest rate until it matures.

However, the inexperienced investor is not usually aware or very knowledgeable with respect to the trading of Treasury Bonds on a secondary market and that their price fluctuates according to interest rates and demand.

For example, in early 2008, the interest rate for a 30 year Treasury Bond was approximately 4.50%.

The par value of the bond would have been $100.

Therefore, the purchaser would receive $4.50 per year on each $100 unit until maturity.

Bear in mind, that $4.50 is received no matter how future interest rates are adjusted. If interest rates go up to 6%, $4.50 is still received. If interest rates go down to 2%, $4.50 is still received.

On the secondary market where one could buy and sell Treasury Bonds, the price of a given bond is adjusted to reflect current interest rates according to its ORIGINAL CASH YIELD.

The price of the bond purchased at $100 yielding 4.5% will go up if the interest rates go down. It will go up so that the new interest rate matches the $4.50 that is received until maturity.

Therefore, after the September of 2008 CRASH, interest rates on the 30 year Treasury Bond fell to as low as 2.8%

If you sold your 4.5% yielding bond when the interest rate was 2.8%, the price would have reflected that you receive $4.50 in cash and would be adjusted so that the buyer would be receiving 2.8%.

Because it continues to pay $4.50 per $100, that would put the purchase price of the 4.50% bond mathematically at approximately $160. $160 times 2.8% equals $4.48

However, that premium of $60 would have to be distributed over the time period that it would take the bond to mature, and the actual selling price would be more in the neighborhood of $130-$135.

That would produce a profit of at least 30% while collecting a 4.5% return.

TREASURY BONDS NOT ONLY FUNCTION AS A SAFETY FACTOR, but will often appreciate to OFFSET LOSSES in RISK EQUITIES!