I’VE LATELY BEEN getting a lot of questions about a pair of lookalike investments: U.S. Treasury bonds, which are currently yielding around 1.8% to 2.6%, and online bank savings accounts, which offer similar yields. In other words, you could earn just as much interest in a simple savings account as you could if you tied up your money for a period of months, or even years, in a government bond.
The question I keep hearing: “Why in the world would anyone choose government bonds? Why not just stick with cash for now, until bonds start paying more?”
If you’re concerned about risk, I see two reasons you shouldn’t ignore Treasury bonds. The first is relatively straightforward: While bank accounts are insured by the federal government, via the FDIC, that coverage is capped at $250,000 per account. A Treasury bond, on the other hand, is also backed by the U.S. government, but without any limit. If your savings exceed the FDIC threshold, that would be a good reason to choose Treasury bonds over cash, even when the interest rates are the same.
The second reason is more subtle and maybe more important. It has to do with correlation.
What’s correlation? In simple terms, it’s the degree to which one investment zigs when another zags. It’s the fundamental principle behind diversification. When investments are positively correlated, they tend to move up and down together. On the other hand, when investments are negatively correlated, they’ll often move inversely—that is, when one goes down, the other will go up, and vice versa. For that reason, investments with negative correlations to stocks are the holy grail of diversification. They help preserve the value of your portfolio when the stock market is depressed.
How do Treasury bonds and bank savings accounts stack up in terms of correlation? This is where our two lookalike investments start to look less alike. The correlation between stocks and cash is zero, which means they move completely independently of each other. That’s a good thing, and that’s why cash is a key tool for diversification.
But now consider Treasury bonds. Over the past 15 years, according to research from Morningstar, Treasurys have delivered negative correlation. This is the critical difference between government bonds and cash. While they may look identical because of their interest rates, that ignores the benefit bonds may offer the next time the stock market goes through a rough patch.
While nothing in the world of investments is guaranteed, this negative correlation between stocks and government bonds has been historically reliable. And I expect it to continue, because it makes logical sense. When the economy worsens and the stock market falls, investors rush to safer assets, pushing up their prices. At times like that, U.S. government bonds are perceived as the safest available refuge.
One final thought on this topic: You’ll notice that I have been referring here only to government bonds. While there are many other kinds of bonds, I favor only government bonds—including those issued by municipalities—because they’re the only ones that deliver this valuable negative correlation to stocks.
I’d be especially wary of high yield bonds, otherwise known as junk bonds. In a low-rate environment, some people favor these bonds, which pay higher interest rates. But that ignores their risk. Over the past 15 years, high yield bonds have exhibited a strong positive correlation with the stock market. Translation: They offer scant diversification benefit. For that reason, high yield bonds—in my opinion—have no place in an investment portfolio.
Adam M. Grossman’s previous articles include Danger Ahead, Know Doubt and Beat the Street. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.
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