Bill Gross Likes The 5 Year Treasury. Here's Why.

Includes: AGG
by: Learn Bonds

In a recent interview with Bloomberg's Erik Schatzker and Stephanie Ruhle, Bill Gross said that PIMCO currently likes the 5 year treasury.

Why most people hate treasuries right now:

The large majority of investors and market pundits think that treasuries of all flavors are currently a terrible investment. So, when the world's largest bond fund manager says that he likes the 5 year treasury, we take notice.

The 5 year Treasury is currently yielding .80%. In addition to the fact that less than a 1% yield for the next 5 years is not very exciting, there are two other reasons that most people disagree with Gross that the 5 year is a good investment:

The duration on the 5 year treasury is about 4.89. That means for every 1% move in the 5 year treasury rate, the value of the note drops by about 4.89%. So in order for you to wipe out your whole yield for the year, the interest rate on the 5 year treasury only needs to rise by about 16 basis points.

You can get a 5 year CD that currently pays 1.7%, or more than double the current rate on the 5 year treasury bond.

So why does Bill Gross like the 5 year treasury?

Two reasons:

The first reason is that he feels that the Fed is going to remain active on the shorter end of the yield curve, keeping shorter term rates low for a good amount of time to come. So, very simply he feels that the chances of rates rising significantly from here in the near term are slim.

The second reason is that Bill doesn't plan on holding the 5 year treasury to maturity. By employing a strategy called rolling down the yield curve, he plans to increase the return that he earns on the 5 year to around 1.5% over the next year.

What is rolling down the yield curve?

It is when you buy a longer term bond and then sell the bond as it moves towards its maturity date. The strategy is employed when the yield curve is upward sloping, meaning that longer term rates are higher than shorter term rates. Assuming rates stay relatively stable between the time you purchase the bond and the time that you sell it, the bond will increase in value as it moves towards maturity (this makes some assumptions, like the bond is not trading at a premium, for simplicity's sake). This gives you more bang for your buck as you benefit not only from the interest payment on the bond, but also from the price appreciation.

Lets look at what Bill Gross is probably thinking:

On the day this article was written, the 5 year treasury was yielding .78%. That same day, the 4 year treasury was yielding .59%. So that is a difference of .19%. Now the 4 year treasury has a duration of around 3.9. If you multiply .59 X 3.9 you get .74%.

If you buy the 5 year treasury today and sell it in 1 year then, assuming interest rates do not change, you earn the .78% yield on the bond + the .74% price increase in the value of the bond. That gives you a total return of 1.52%. (this again makes a few assumptions for simplicity's sake).

While that's still not as good as what you can get from a top-paying 5 year CD, you do not have to lock your money up for 5 years. Another top bond fund manager, Jeff Gundlach, thinks that the 10 year treasury may not be such a bad investment right now either. Learn why here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.