We All Want the Best Returns With the Less Risk
Finding respectable returns in the capital markets requires understanding what macro-cycle the economy is in. We are currently in an inflationary and high debt period, creating an environment where stocks cannot get any traction to resume the bull market—leaving the market more conducive to trading than investing.
Interest rates have risen from near zero to over 5.5 percent, resulting in higher mortgage rates, credit card finance charges, corporate and government borrowing issues, and many other problems.
High-interest rate environments are often bearish for stocks, and investors typically see lower returns in their equity portfolios. Investors looking for fixed income find better returns during these periods as the current rates are high, often offering a positive real interest rate (yield is higher than inflation.)
In contrast, low-interest rate environments are bullish for stocks, and investors typically see better returns in their equity portfolios. Investors looking for fixed income struggle during these periods as the current rates are low, often offering a negative real interest rate (yield is lower than inflation.)
While many complain about the bear market in interest rates, there are excellent opportunities to capitalize on, while others shun the interest rate market. Let's explore these opportunities and the vehicles available to assist in achieving a return. And then, we will delve into each product's nuances to illustrate each's pros and cons.
Cash Treasuries or Treasury Exchange-Traded Funds (ETFs)
Two popular securities that allow investors to participate in the interest rate arena are Cash Treasuries, offered by the government, and ETFs traded on stock exchanges through brokerage firms. What are the benefits and differences of the two:
Cash Treasuries
- Maturity and Yield: Cash treasuries come in various maturities, from short-term (e.g., T-bills) to longer-term (e.g., T-notes and T-bonds). If you have a specific investment horizon or yield target, you can choose the individual security that best aligns with your goals.
- Safety: US Treasuries are considered one of the safest investments because the full faith and credit of the US government backs them. Investing in Cash Treasuries allows you to hold them until maturity, ensuring the return of the principal amount and accrued interest.
- Liquidity: You can buy and sell individual Treasury securities directly through the US Department of the Treasury's website-Treasury Direct, primary dealers, or the secondary market, providing a high level of liquidity, especially for T-bills.
- Control: When investing in individual treasuries, you have more control over your portfolio's composition and can tailor it to your needs.
Investing in Treasury ETFs:
- Diversification: Treasury ETFs pool together various Treasury securities, offering immediate diversification through multiple maturities, helping to spread risk and potentially reduce the impact of interest rate fluctuations.
- Convenience: ETFs trade like stocks on stock exchanges, making buying and selling them during market hours more manageable and convenient than buying and managing individual securities.
- Interest Rate Risk: Treasury ETFs, like individual Treasuries, are subject to interest rate risk. However, they may not provide the same control over maturity dates as investing in individual securities.
Understanding the Treasury ETFs
Treasury ETFs may be convenient for investors but differ significantly from Cash Treasuries. The most prominent difference is that ETFs do not pay any interest as a Cash Treasury would. The only way to profit from a Treasury ETF is to have capital appreciation. The share price must rise.
Investors may buy Treasury ETFs because they appear "cheap" after declining prices. But, like a stock price falling, a Treasury ETF can drop even more than it is priced now. The investor would have to wait for the price to rebound before they can make a profit with their ETF purchase. Nobody knows how high yields will go and where the Treasury ETFs will bottom.
ETFs traded in a taxable account will be subject to Federal, State, and Local taxes and short-term capital gains if held for less than one year.
Like other exchange-traded ETFs, Treasury ETFs have management fees built into the share price.
Many investors will find better returns in interest-rate bull markets where capital appreciation has a better opportunity. Some Treasury Reverse ETFs appreciate when prices decline, but investors should be aware that many use leverage of 2 to 3 times.
A More Logical Approach to Treasury Investing
Buying a cash Treasury bill, note, or bond has many benefits over Treasury ETFs. The most prominent benefit is that you earn interest and can't lose your principal regardless of where interest rates go, as long as you hold it to maturity. An overlooked feature of earning interest is that you are making money on weekends and holidays with a Cash Treasury. Try doing that with an ETF when the market is closed.
TreasuryDirect is a popular platform for buying and managing US Treasury securities, such as Treasury bills, notes, bonds, and inflation-protected securities (TIPS). Like any financial service, it has its own set of pros and cons:
Pros:
- Safety and Security: US Treasury securities are backed by the full faith and credit of the US government, making them one of the safest investments available. When you buy through TreasuryDirect, you eliminate the risk of dealing with a third-party broker.
- No Costs: There are no fees or commissions when buying or holding Treasury securities through TreasuryDirect. They are a direct purchase from the US government, which can lead to cost savings compared to buying through a broker who uses the secondary market with a bid/ask spread. Some brokers allow placing buy trades with the Treasury Direct auction process. We will cover this further in the article.
- Convenience: TreasuryDirect allows you to manage your Treasury investments online, including reinvesting or redeeming securities. It's a user-friendly platform that simplifies purchasing and managing Treasury securities.
- Automated Reinvestment: You can set up automatic reinvestment of your maturing securities, making it easy to reinvest your funds in new Treasuries without manual intervention.
Cons:
- Lack of Diversification: While US Treasuries are safe, they sometimes offer lower returns than other investments, such as stocks. You may need to look beyond Treasury securities to build a diversified investment portfolio.
- Principal Risk Selling Before Maturity: Treasury securities have fixed maturities, and if you need to sell the bill, note, or bond before it matures, you will have to sell them in the secondary market, which could result in capital losses if interest rates have increased (price went down) since you bought the security.
- Account Setup: Setting up and managing a TreasuryDirect account may involve paperwork and steps, which could inconvenience some investors. These accounts are self-directed and require investors to monitor their investments and activity.
Knowing This About Treasury Direct Will Save You Some Frustration
Whether a TreasuryDirect account or a brokerage account that trades treasuries is better depends on your financial goals, preferences, and needs. Both options have their advantages and disadvantages.
If an investor buys Treasury Bills only, then Treasury Direct is a perfect choice for a self-directed investor. The duration of the investment is so short that the investor will probably not sell it before maturity.
However, suppose an investor invests in Treasury notes or bonds with 2 to 30 years of maturity. In that case, there is a higher probability they may need to sell the Treasury before it matures.
Treasury Direct has a streamlined and highly efficient way of purchasing Treasuries. But, they cannot sell Treasuries. Working through a bank, broker, or dealer to sell a Treasury marketable security would be best. For this, the investor must transfer the Treasury to those mentioned above to be sold in the secondary market, which is highly liquid.
From the Treasury Direct website, the process to transfer a Treasury security to sell:
To transfer a security to a bank, broker, or dealer, you need this information from them:
- The Financial Institution's Wire Name
- The routing number (ABA number) for that financial institution
- The agent or broker's name and phone number
- The name and account number of the account into which the security is going
When you have that information:
- Go to your TreasuryDirect account.
- Choose the Manage Direct tab.
- Identify the security or securities you want to transfer.
- Choose External Transfer.
- Open the link for FS Form 5511, "TreasuryDirect Transfer Request."
- Fill out the required information and follow the instructions on the form.
Completing the process requires mailing the 5511 form to Treasury Direct. Treasury Direct has been overwhelmed with investors wanting to purchase Treasury securities. The typical turnaround time was 13 weeks. Today, investors are waiting up to 19 weeks.
To eliminate this issue, Treasury transactions that you feel might be sold before maturing should be bought in your equity brokerage account. Selling the Treasury security from this account is as easy as selling a stock. You notify the brokerage firm and place a sell order for your Treasury security, and in seconds, your transaction is complete.
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