Which Treasury Bond Should I Buy?

The new year has come and past, and we've seen quite a precipitous drop occur in the S&P (SPY). The recession watch team is on full alert, fear is high, and the flight to quality has continued just as I've discussed in my early December blog entry advocating the purchase of treasuries. In that entry, I discussed the yield upside possibilities of the long maturity treasury products. Here I intend to continue the discussion into more practical matters on how to best take this position in an investment portfolio.

Here is a chart showing sensitivity of bond price to yields. Here the most volatility is found in the bonds dated the farthest out. Maturity's impact on convexity is clear here.

So what bond do you buy? What part of the curve gives the the most bang for the buck, as well as the best volatility adjusted risk/reward scenario? Believe it or not, in this case where the most volatility lies is where the best risk/reward ratio exists. In the following charts, I divide percent risk (in a losing scenario) versus percent gained (using a 2.5% yield target for 10 and 30 year maturity treasuries) to find a ratio. The higher the number, the more potential downside versus the amount of upside. The lower the number, the more balanced the risk/reward for that maturity.

Interestingly enough, the risk/reward ratios become particularly more apparent in the most adverse scenarios. While an inflation measuring move towards 8% provides the most losses (-40% on 30 year maturity) on the far end of the curve, a move to 2.5% from 4.3% yields a 36% gain. At the same time, a 10 year treasury position will net an 8% gain in a move from current 3.8% yields to 2.5%. An adverse move to 8% on the ten year will yield a 21% loss. This shows a lopsided risk/reward profile on shorter dated maturities versus longer.

The basis of the data in these charts is conceived from current ten year yields and thirty year yields at 3.8% and 4.3%. There is a few basis points of error in the thirty year data, but nothing to disturb or distort what is presented in these charts.

A final chart shows what type of principal gains and losses you are likely to experience with respective moves in the yield curve.

The conclusion is obvious: Buy the longest dated maturities (2036, 2037) possible if you are anticipating the yield curve to flatten or even invert amidst this possibly emerging recession. Your principal risks are higher, but the potential reward is enough to offset this.

Bond funds versus outright Treasuries?

Treasuries all the way, mainly for ability to choose the correct maturity.

When looking for treasury bond funds, be sure to check the average maturity. The iShares Lehman 20+ YR Treasury Bond ETF (TLT) is the longest I could find, at 23 years. The Vanguard and Fidelity Long Term Treasury Funds are shorter, averaging about 17 years to maturity. The best way to get 30 year exposure is to buy the 30 year bond outright. The leveraged Direxion [DXKLX] 2.5x treasury product is levered to perhaps the portion of the yield curve with the worst risk/reward. And the Rydex [RYGBX] 1.2x long maturity fund has excessive loads and fees, making it difficult to justify the small extra 20% leverage. I could not find the average maturity, but judging by its performance, it is likely close to TLT.

Disclsoure: Author has a long position in some of the above mentioned securities

Comments

[Long-ShortGuy]

Any thoughts on (a) TIPS and (b) the new foreign treasury bond ETF (BWX)?