Home About Archives RSS Feed

The Retired Investor: U.S. Treasuries Not Risk Free

By Bill SchmickiBerkshires columnist
The recent calamity in the banking sector is complicated, but one issue stands out. Even the safest of investments have risk.
 
Understanding the relationship between bond prices and interest rates is extremely important. Bonds, overall, are considered safer investments than stocks and history indicates that bonds have been less volatile than stocks most of the time. However, when interest rates rise, bonds can get hurt for a variety of reasons, and credit risk is at the top of the list.
 
Credit risk refers to the possibility that a corporation (or a government entity) could default on a bond they have issued. That happens when the issuer fails to pay back the principal or cannot make interest payments. Normally, U.S. government bonds, called Treasuries, have lower credit risk. Presently, however, even Treasuries have some credit risk. If Congress refuses to increase the debt limit by this summer and allows the country to default, the consequences for our government debt could be grave.
 
However, all bonds have interest rate and duration risk. Bond prices and interest rates move in opposite directions. As interest rates fall (as they have for much of the past decade), the value of fixed-income investments rise. Since last year, interest rates have risen substantially due to the Federal Reserve Bank's efforts to combat inflation.
 
This is where duration risk comes in. Let's say you have long-dated U.S. Treasury bonds that do not come to maturity for 10, 20 or even 30 years from now. If you hold them to maturity, you will receive your principal investment back plus whatever interest rate coupon was promised. However, if rates rise (as they are doing now), and for whatever reason, you sell your bonds before their maturity date, you could end up receiving less than what you paid for your bond.
 
In general, duration is expressed in terms of years and generally bonds with long maturities and low coupons have the longest duration. These bonds are more sensitive to a change in market interest rates and thus are more volatile in a changing interest rate environment. Over the last year, the Fed has increased interest rates at its fastest pace in recent history, which has caused the price of bond holdings to decline substantially.
 
Enter the Silicon Valley Bank (SVB) stage left. SVB, like most banks, relies on a mixture of short-term and long-term financing. The short-term side largely consists of customer deposits. A bank's assets typically consist of long-term loans that get paid back with interest over time as well as bonds the bank purchases that pay out over the term of the bond.
 
More than half of SVB's assets at the end of last year were "safe" bonds issued by the U.S. government or federal mortgage institutions, which they had purchased before the Fed's tightening policies began. Safe from default risk, maybe, but not from the climbing interest rates. And most, if not all, of those bonds, were low coupon, and long-term in nature — a classic case of duration risk.
 
The nightmare that all banks fear is a bank run. Think of "It's a Wonderful Life" and George Bailey's Building and Loan, a small community bank in Bedford Falls. Depression-era depositors, fearing for their financial lives, rushed to take their money out of Bailey's bank. Few depositors understood how credit and loans work. They thought their money was simply sitting in the safe. George tried to explain the concept but ended up making good for his customers by giving them his honeymoon money.
 
In the case of SVB, the same thing occurred, although, unlike George Bailey, the management of the bank could not make their depositors whole. For most depositors, there was no need to stand in line. A simple electronic transfer via computer transferred millions out of the bank in seconds. As a result, SVB was forced to sell bonds at a loss to satisfy depositor demands until it couldn't. The rest is history.
 
What may some readers have in common with SVB? In today's market, there has been a mad rush to capture higher interest returns after years of an interest rate famine. The U.S. Treasury markets, especially on the short end, have seen yields of 5 percent or above for six-month, one-year, and two-year notes and bills.
 
Putting excess cash into these high-yielding instruments and intending to hold them to maturity is a reasonable financial strategy. However, if you need to sell them to raise cash for an emergency may leave you open to losses. Remember that a bond's yield is not the same as the interest rate coupon promised at maturity on that instrument.
 
A six-month note may have been issued with a fixed 1.75 percent coupon, however, because of the Fed's recent interest rate hikes, the price of the note has declined. As it does the yield has climbed. 
 
You are in effect, buying that note at a discount to the original purchase price. If you hold the instrument to maturity, you will receive the full-face value of the note when it was issued, plus the coupon. That is ideal. But remember, yields will go up and down over time in an inverse relationship with the instrument's price depending on market conditions. If things change and you need to sell early, you may face the same issues as SVB. That is the risk you are taking when you buy Treasuries.
 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.

Anyone seeking individualized investment advice should contact a qualified investment adviser. None of the information presented in this article is intended to be and should not be construed as an endorsement of OPI, Inc. or a solicitation to become a client of OPI. The reader should not assume that any strategies or specific investments discussed are employed, bought, sold, or held by OPI. Investments in securities are not insured, protected, or guaranteed and may result in loss of income and/or principal. This communication may include opinions and forward-looking statements, and we can give no assurance that such beliefs and expectations will prove to be correct. Investments in securities are not insured, protected, or guaranteed and may result in loss of income and/or principal. This communication may include opinions and forward-looking statements, and we can give no assurance that such beliefs and expectations will prove to be correct.

 

     

Support Local News

We show up at hurricanes, budget meetings, high school games, accidents, fires and community events. We show up at celebrations and tragedies and everything in between. We show up so our readers can learn about pivotal events that affect their communities and their lives.

How important is local news to you? You can support independent, unbiased journalism and help iBerkshires grow for as a little as the cost of a cup of coffee a week.

News Headlines
Pittsfield Car Crash Knocks Radio Stations Off Air
North Adams Christmas Trees Installed for 2024
Talk Slated on Growth of North Adams Art Community
Pittsfield BOH Condemns Two Homes
Triplex Announces Screening of 'A Different Man'
Lee Man Killed in Single-Car Accident
Mass Wildland Fires Spiked in October
Clark Art Concert By Circuit Des Yeux
Louison House Celebrates Growth, Programs at Annual Meeting
Dalton Officials Sign Off on Bardin Land Sale
 
 


Categories:
@theMarket (507)
Independent Investor (452)
Retired Investor (214)
Archives:
November 2024 (1)
November 2023 (3)
October 2024 (9)
September 2024 (7)
August 2024 (9)
July 2024 (8)
June 2024 (7)
May 2024 (10)
April 2024 (6)
March 2024 (7)
February 2024 (8)
January 2024 (8)
December 2023 (9)
Tags:
Rally Congress Federal Reserve Interest Rates Bailout Metals Deficit Economy Energy Banks Pullback Stimulus Recession Commodities Selloff Currency Election Stock Market Jobs Oil Japan Taxes Stocks Crisis Euro Qeii Debt Europe President Debt Ceiling Unemployment Markets Retirement Greece Fiscal Cliff
Popular Entries:
The Independent Investor: Don't Fight the Fed
Independent Investor: Europe's Banking Crisis
@theMarket: Let the Good Times Roll
The Independent Investor: Japan — The Sun Is Beginning to Rise
Independent Investor: Enough Already!
@theMarket: Let Silver Be A Lesson
Independent Investor: What To Expect After a Waterfall Decline
@theMarket: One Down, One to Go
@theMarket: 707 Days
The Independent Investor: And Now For That Deficit
Recent Entries:
@theMarket: Will Election Fears Trigger More Downside
The Retired Investor: Betting on Elections Comes of Age
@theMarket: Election Unknowns Keep Markets on Edge
The Retired Investor: Natural Diamonds Take Back Seat to Lab-Grown Stones
@theMarket: As Election Approaches, Markets' Volatility Should Increase
The Retired Investor: Politics and Crypto, the New Bedfellows
@theMarket: Stocks Make Record Highs Despite a Wall of Worry
The Retired Investor: Back to the Future in Nuclear Energy
@theMarket: A Week to Remember
The Retired Investor: Economic Storm Clouds Could Be Just Around the Corner