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What is an investor to do?

An investor may play it safe by holding cash but that can be costly, as little or no interest income is earned. This might result in the investor reducing the principal balance to live on. This can further reduce interest income earned. A catch-22. The lower interest rates decline, the more the principal balance is reduced.

An investor may swing for the fence with longer-term bonds, as they generally have a higher yield, but that can be costly. Income might be known. But if, (when), interest rates increase, the decline in bond prices might unsettle some investors. The market value of the bond holdings may have a noticeable decline. However, if some of the interest income can be reinvested then the income generated might be greater than originally expected.

Does an investor play it safe and hold cash that pays a few basis points, or swing for the fence and buy long-term Treasury bond that currently pays 2.70%?

Each has it own risk - reward.

Cash grows in real value when asset prices decline, or deflation appears. The real cost of buying real estate might have declined, falling prices. But the cost of insurance and taxes might be a different story.

An investor could use a fixed income mutual fund or ETF / ETN as a means to gain bond market exposure. Or the investor could craft a fixed income portfolio with individual issues. The benefits of mutual funds or ETF / ETN is the quick diversification. A benefit of individual issues is a known maturity date when the principal will be redeemed. The drawback to mutual fund or ETF / ETN is the unknown timing of a tax liability. The drawback to individual issues is the difficulty in reinvesting interest payments and / or generally higher transaction costs.

At current yields, U.S. Treasuries held to maturity are not that attractive on a yield or total return basis. However, for those inclined to trade, the total return potential is great. Each 1-basis point decline in interest rates has an increasing positive effect on the price. A few examples below show the value of 1 basis point at various yields. The lower the yield, the greater the impact of a 1-basis point move.

A perpetual bond with a 4.00% coupon discounted at 4.00% is valued at 100.00. A 1 basis point move to 3.99% increases the value to 100.25. A basis point is worth 0.25.

A perpetual bond with a 4.00% coupon discounted at 3.00% is valued at 133.33 with a 1 basis point move to 2.99% increasing the value to 133.78. A basis point is worth 0.45

A perpetual bond with a 4.00% coupon discounted at 2.00% is valued at 200.00 with a 1 basis point move to 1.99% and the value increases to 201.01. A basis point is worth 1.01.

A perpetual bond with a 4.00% coupon discounted at 1.00 is valued at 400.00 with a 1 basis point move to 0.99% the value jumps to 404.04. A basis point is worth 4.04.

The lower yields fall the greater price impact of a 1 basis point move.

Bond ETFs that might be worthwhile to consider for those thinking interests rates may stay stable or decline include.

EDV is the Vanguard Extended Duration Treasury Index.

  • $127.71 Closed June 15th
  • 2.76% SEC Yield
  • 0.13% Expense Ratio
  • 24.8 Average Maturity (Years)
  • $222.4 Million Share Class Total Net Assets

More data available here.

TLT is the iShares Barclays 20+ Year Treasury Bond.

  • $126.40 Closed June 15th
  • 2.50% SEC Yield
  • 27.99 Weighted Average Maturity (Years)
  • 0.15% Expense Ratio
  • $3.9 Billion Total Net Assets

More data available here.

ZROZ is the PIMCO 25+ Year Zero Coupon Treasury.

  • $118.11 Closed June 15th
  • 2.72% SEC Yield
  • 29.90 Effective Maturity (Years)
  • 0.15% Total Expenses
  • $173 Million Total Assets

More data available here.

Bond ETF that may offer some protection from increasing interest rates:

PLW is the PowerShares 1-30 Year Laddered Treasury.

  • $33.40 Closed June 15th
  • 1.58% SEC Yield
  • 1.83% Yield to Worst
  • 15.36 Years to Maturity
  • 0.25% Expense Ratio
  • $168.5 Million Market Value

More data available here.

An investor may want to use a combination of cash and various bond ETFs to construct a portfolio based upon their risk-reward profile. The options are endless. Be sure to read and understand the ETF prospectus to understand its risk.

Being in the camp of expecting higher interest rates, a combination of cash and ETFs might be the answer. Better to be a steady single and doubles hitter than swinging for the fence and missing. Even though the home-run hitter may get the big bucks, his/her career might not outlast the consistent singles hitter's.

Source: Cash Or Bonds: Swing For The Fence Or Be Safe?