Fine, tailored suits, international renown, and fancy gadgets–no, this isn’t the next movie about the world-famous British super spy, James Bond. This is the world of the United States Department of the Treasury.
You may be thinking, ” I thought the Treasury was just full of bankers and accountants?” Well, you’re not wrong–at least after 2003, when the Secret Service moved from the Treasury to the Department of Homeland Security (but that’s just splitting hairs at this point). The Treasury, even without the agents in dark glasses, are still a force to be reckoned with.
Currently, the Treasury is responsible for printing our currency, collecting our taxes, paying federal debts, and whole host of other accountant-y functions. However, the function that is most interesting to us at the present time is the issuance of fixed income securities, aptly referred to as “Treasuries.” But, what is fixed income?
Fixed income securities yield a set amount of return, over a set period of time and at regular intervals (now, this is not without fluctuations, but we will only be considering those securities that fall in-line with this notion…for now). The most common type of fixed income securities are bills, notes, and bonds (and many refer to them all as bonds, for simplicity), which are issued by countries, cities, corporations, and everyone in-between. As mentioned, there is a certain amount of return paid to the holder over time, which is referred to as the bond’s coupon. Coupon is expressed as a percentage of the bond’s value when issued, which is usually in denominations of $1,000. This coupon can be paid-out monthly, semi-annually, or annually, but most often it is semi-annually. Bringing it all together, for example, the City of Peoria, Illinois can issue a $1,000 bond that pays a 4% semi-annual coupon, but why? (Similarly, will the bond “play in Peoria?”)
The best way is to think of a bond is a request for a loan by the issuer: essentially, the issuer will have a certain project or objective that they need to raise money for (just like a person might need a loan to buy a house), and will put the “request” out to the world in order to see who is willing to loan them the money in small amounts. Those who decide to loan them the money (again, in $1,000 increments) will be entitled to the coupon that is offered for the length of time that they hold the loan. This length of time is set in advance by the issuer based on how long it is until they expect to pay back the initial investment. If Peoria plans to build a new rail line for all the people travelling for product testing, and they find that the project needs $100 million to be completed, they may issue bonds for some, or all, of the cost. This may end up in the form of 5-, 10-, 20-, and 30-year bonds, at $25 million each maturity. However, since the investors in each of these bonds will have to part with their money for different spans of time, they will all require a different return on the investment. This is because inflation is likely to deal a relatively minor blow to the 5-year bond holders when compared to the 30-year bond holders, who will potentially be subject to 30 years of currency deflation. Therefore, even though every investor will want a higher yield, long-term investors will demand a higher yield than that of the 5-year investors. For example, the yields on Peoria bonds may be 2%, 3%, 4%, and 5.5%, respectively.
Alright, this sounds pretty complicated, not really something that people would want to invest in very often, right? Wrong. In fact, the U.S. Treasury issues new sets of bonds weekly, with over $14 trillion in securities outstanding, and the Treasury market is among the most liquid markets in the world; meaning that, should you want to sell your position, you would have no problem doing so. What makes fixed income securities, especially those from the U.S. Treasury, so desirable? Two major considerations: time horizon and risk.
If you remember Alex’s article about making investment choices, time horizon is loosely defined as the length of time that one will hold a security before liquidating it. More simply: how long you’ll hold the security until you have to sell it in order to use the money for something else. Not too long ago, I had falsely believed that equities were short term investments, since people would talk about day trading stock, and that fixed income was all long-term since the maturities could be as long as 30 years. Well, surprise: the cardinal rule of portfolio management is that the longer the time period a person has to invest, the more they should be in risky securities (like equities), and the shorter the time period, the more they should be in fixed income (like bonds). This is because the price of an equity has the potential to fluctuate greatly over a short period of time; if you need the money next week, your Friday withdrawal might be right in the middle of a short-lived correction, but you’ll have lost 10% of your investment. In terms of fixed income, there are Treasury bonds with maturities of as little as 4 weeks (technically Treasury bills, but you get the point). Matching the maturities of your investments with your time horizon has additional benefits, too: hypothetically, pairing a 30-year Treasury bond with your 30-year mortgage would create additional regular income to help pay off you home.
Risk is a very similar story, especially when considering Treasury securities. The United States Government is considered the gold-standard of risk-free investments; they have the highest credit rating (lowest probability of being unable to payback obligations) from the major rating agencies, save for Standard & Poor’s, who lowered their rating in 2011. For all intents and purposes, we, and nearly everyone else, will regard all U.S. Treasuries as risk-free, which is why everyone from hedge funds, to pension funds, endowments, and retirees invest in Treasury securities in order to mitigate risks in their portfolios. These risk-free investments offer anywhere from 0.46% to 3.06% (as of end-of-day on 12/5/16), making it a much better alternative to hiding the money under your mattress.
However, these yields are not high, by any stretch of the imagination. This low-yield environment has lead investors with the need for high-returns at a low level of risk , particularly pension funds and endowments, to “hunt for yield.” This has strengthened the case for creating a new set of the most liquid, lowest risk bonds: 50- and 100-year Treasury bonds. Theoretically, these bonds would have two huge benefits: cheap borrowing for the U.S. Government, and higher yield in a low-yield world. Going back to the discussion of Peoria funding their new railway, the U.S. Government could take advantage of low yields, both at home and abroad, to borrow a lot of money “on the cheap” for a very long time. The second consideration, high yield, would benefit all of the pension and insurance funds that are obligated to give their beneficiaries a certain return annually, but haven’t been able to do so without taking on undue risk. With 100-year bonds, hypothetically receive 7% return from a risk-free instrument, while the rest of the market is only getting 3%.
At the end of the day, a hot tech company’s 5% bonds will never be as “sexy” as their stock that just increased by 20% overnight because their new cellphone was leaked, but it may be the better choice for a lot of investors around the world. After all, the value bond market is significantly larger than that of the equity market, so maybe there is hope for it being as suave as our favorite secret agent.