Mar 5, 2018
We are very content to include Treasury bonds in the portfolios because they offer several key features; they accurately reflect the level of interest rates at any given time, their quality allows for worldwide acceptance and demand, they are non-callable (which makes for better portfolio management), they have the tightest trading spreads, they are available in large quantities and are exempt from state income tax. In practice, at whatever price level treasuries trade is the current market rate of interest.
U.S. Treasury bonds are the safest securities in the world, because they are a direct obligations of the U.S. government. They are safer than insured time deposits from the banks, safer than savings & loan company deposits, safer than credit unions, insurance companies, annuities or mortgages. Banks and savings & loans deposits are insured by the U.S. government through FDIC insurance (subject to withdrawal terms and dollar limits). Insured mortgages and government agencies (ex. Fannie Mae) are one step removed from the U.S. government but they are considered "moral obligations" because they are government sponsored businesses.
All other bonds are priced in relationship to U.S. Treasury securities. Their prices are based on the quality of the issuer and the size of resources it may draw upon. There are rating services that assign corporate, financial notes and municipal bonds a quality rating (see the table below). As the credit quality declines from AAA, the yield rises because the repayment risk rises. Recently, the spread, or difference between treasuries which are rated AAA and other bonds, has been very small. This means there is less of a difference in the yield or income between differently rated bonds. This narrowing is especially true when the economy is strong and default risks are low. In recent years because rates have been ultra-low, the spreads between quality bonds has
never been narrower. Investors have been seeking higher returns in a low interest rate world, driving prices up and narrowing spreads on lesser quality bonds. As demand increases to expand the economy the spreads will increase and push interest rates higher. The expanding economy will create more inflation until the Fed raises rates high enough to stall the economy inducing a recession and lowering inflation. Then spreads widen further percentage wise, even though interest rates are now declining because quality becomes paramount as the recession reduces the lesser quality companies’ payment ability.
We have removed the bond ETF's from our models and replaced them with U.S. Treasuries. As interest rates rise, the value of the ETF will decline greater than an individual bond. This is because a bond ETF or bond mutual fund seeks to maintain a maturity range (also known as constant maturity). Each year an individual bond gets closer to maturity, which reduces its volatility, where as an bond ETF or bond mutual fund will sell bonds as they age and replace them with the original maturity bonds. The other reason is that spreads will widen. We have purchased Treasury bonds with very short maturities that return about what the corporate bond ETF's (that were sold) were yielding. If interest rates continue to rise during the next year, our bond portfolio will be basically unaffected, where others will see a larger decline in the value of their bonds portfolios and fixed annuities. At some future date, when interest rates are higher, we will lengthen maturities, increase the income and hopefully gain some increase in portfolio values.