As new developments in the euro zone raise concerns about global contagion, the market for 10-year U.S. Treasury securities is feeling some effects.1 In a trend that some observers describe as an attempt to reduce perceived risk, investors are buying 10-year U.S. Treasury securities in large numbers, sending prices up and yields down.
On Thursday, May 17, 2012, the yield of 10-year U.S. Treasury securities was 1.70%. By comparison, the yield averaged 3.98% between January 1, 2001, and May 21, 2012.2 As with all bonds, investor demand influences prices and yields, and it is important to understand this dynamic when considering U.S. Treasury securities.3
Supply and Demand
The market for U.S. Treasury securities is likely to be robust when investors perceive that a recession or higher inflation could be imminent. In this type of scenario, investors may appreciate the constant rate of return and the backing of the U.S. government that U.S. Treasury securities offer. When large numbers of investors purchase U.S. Treasury securities, investors bid up prices and yields fall. The Federal Reserve also influences prices and yields when it buys and sells U.S. Treasury securities.
When market conditions are unfavorable, the opposite situation can occur, with investors selling securities, which causes prices to decline, and yields to rise. In this type of scenario, when the U.S. Treasury issues new bonds, it is forced to offer higher interest rates to entice investors to buy.
In the current market environment, the rate of inflation has exceeded the yield of 10-year U.S. Treasury securities. Inflation as measured by the Consumer Price Index was 2.3% for the 12-month period ending April 30, 2012.4 If this situation continues, investors with large allocations to 10-year U.S. Treasury securities could earn a return that is below the rate of inflation, and this scenario would diminish long-term purchasing power.
Factors to Consider
When evaluating the risk and potential return associated with U.S. Treasury securities, it may be beneficial to keep the following points in mind.
- Because market conditions can change quickly, some investors diversify their allocation to fixed-income securities with corporate bonds, municipal bonds, or other fixed-income securities that may react to a different set of value drivers.5
- Combining bond investments with assets such as equities may reduce long-term volatility because equities historically have not moved in tandem with bonds in response to market or economic developments.6 Past performance does not guarantee future results.
The backing of the U.S. government and a constant rate of return historically have presented benefits for investors in U.S. Treasury securities. When reviewing a potential allocation, opportunities for diversification, current low yields, and long-term purchasing power also may be important factors to consider.
1Government bonds and Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
2Source: The Federal Reserve.
3Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
4Source: Bureau of Labor Statistics, May 15, 2012.
5Municipal bonds are subject to availability and change in price. They are also subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax free, but other state and local taxes may apply.
6Investing in stocks involves risks, including loss of principal. Stocks are measured by the S&P 500, bonds by the Barclays Aggregate Bond Index. The historical tendency of two assets to move in tandem is measured by standard deviation. Returns are for the 20-year period ending December 31, 2011. You cannot invest directly in an index. Past performance does not guarantee future results.
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June 2012 — This column is provided through the Financial Planning Association, the membership organization for the financial planning community, and is brought to you by Ronald J VanSurksum, CFP® , a local member of FPA.