Investment Options: US Treasury Bonds

This is the latest post in a series covering investment selection. Each post covers an asset class, highlighting selection factors to consider and listing filtered investment options.

Bonds have become a very popular asset class since the financial crisis, as seen by the large flows to bond funds in 2009 and 2010 [pdf]. And yet, bonds still seem to be largely misunderstood by investors. Here are a few misconceptions about bonds.

Bonds are low-risk. This may be true for some high-quality, short-term bonds, but most bonds should not be considered low-risk. I consider bonds to be medium-risk, sitting somewhere between stocks and cash on the risk scale. The possibility of losing money is real and should not be ignored.

Bonds can easily continue their recent performance going forward. As of Oct 18, 2010, the 10-year yield on Treasury bonds was 2.5%. If you were to buy that 10-year bond today and hold to maturity, you can expect an annual return of about 2.5%. This is drastically lower than the recent returns of 9% and 13.7% in 2007 and 2008 respectively (Barclays Capital US Treasury Index).

Bonds are a great way to produce income during retirement. Bonds should be a part of your retirement portfolio, but not your entire strategy. As an investor, you should always consider the total return on investment, whether it comes in the form of interest, dividends or capital gains. So giving up total returns or taking on more risk, purely to receive more of your returns in the form of interest, is not the right investment decision.

For bonds, I generally use two sub-categories: US Treasury bonds and US TIPS (Treasury Inflation Protected Securities). I stick to Treasury bonds mainly for diversification: regular Treasury bonds tend to perform better than other bonds when you need it most, when the stock market is doing poorly. I will cover investment options for US Treasury bonds in this post and cover TIPS in a future one.

As with other asset classes, I prefer buying index funds and ETFs that hold numerous bonds instead of buying individual bonds, keeping costs low and diversifying as much as possible. So here are some of my basic requirements when selecting an investment for a given asset class:

• Does it represent the asset class I’m looking for? Since I am looking for US Treasury bonds, the investment I select here should give me exposure to Treasury bonds, not corporate, municipal, or other bonds.
• The investment should be low-cost. Obviously looking at the expense ratio is a great start. Additionally, a high turnover ratio can indicate excessive trading that incurs unnecessary transaction costs and capital gains taxes.
• The fund manager must be committed to the product long term. ETF’s and index funds come and go all the time, so it’s best to stick with companies with a history of managing indexed investments. At the very least, make sure the investment you select is popular enough that it is an unlikely candidate for closure.

The following is a filtered list of ETFs and index funds that satisfies the criteria listed at the end of the post. One factor specific to bond funds is the Average Effective Duration, which is roughly when the bonds mature (in years), with longer bonds being more risky. Another factor to consider is that certain investments are commission-free depending on the broker you use. For example, if you have a Fidelity account, you can trade Fidelity funds and certain iShares ETFs without a commission.

Criteria

• Fund size of at least $250MM
• Net expense ratio of 0.25% or less
• Minimum initial investment of $10,000 or less
• Average effective duration between 4 and 10
• Available to the public without an advisor