Economy, Investment | 8 February, 2019

How to release cash through changes between US Treasury bonds?

Joaquín González Portfolio Manager

As we can see in the following chart, historically, the yield offered by thirty-year US treasury bonds reduces progressively with respect to the return provided by the Fed funds rates with the former even falling 1% below the latter (inversion of the yield curve slope). This reduction in the yield spread, reaches its peak just as the Federal Reserve once again starts to reduce official rates, something that we expect to happen sometime in 2020 or perhaps earlier.

Yield spread between the thirty-year US treasury bond and the Fed funds rate

Taking into account that, as we can see in the following chart, the Fed’s members estimate that the Fed funds rate will reach its maximum level of around 3% by the end of 2019, if the same “yield curve inversion” which occurred in the previous monetary normalisation processes is repeated, the return (IRR) on thirty-year US treasury bonds could fall to 2% (with a yield spread of -1% as in 1989 and 2000) or 2.25% (with a yield spread of -0.75% as in 2006) from its current level of close to 3%.

Fed funds rate forecasts of the various Federal Reserve members

Conclusion

As a result, we propose to switch exposure from US treasury bonds with maturities of ten years or less to thirty-year US treasury bonds, maintaining the portfolio’s same sensitivity to changes in US treasury bond prices (same modified duration). This will mean that in addition to obtaining extra yield, should such an inversion of the yield curve slope occur, we would also free up cash to invest in other assets that provide a higher coupon rate than that offered by US treasury bonds.

Practical example of the proposed change

An investor has 30% of their portfolio invested in five-year US treasury bonds. This bond has a duration of approximately 4.8 years.  Therefore, the sensitivity of the total portfolio to variations of 1% in the yield of this bond would be + 1.44% (if IRR decreases by 1%) and -1.44% (if IRR increases by 1%). This 1.44 years of modified duration (the portfolio’s sensitivity to changes in the IRR offered by the five-year US treasury bond) is the result of multiplying the 30% exposure to this bond by 4.8 years, which is the bond’s approximate modified duration.

If, as we propose, this investor sold their entire 30% in the five-year treasury bond and bought 8% in the thirty-year treasury bond out of the resulting cash, it would mean that:

  1. The investor would have 22% in cash (the 30% they would receive from the sale of their five-year US treasury bonds minus the 8% they would use to invest in the thirty-year bond) from which they could acquire other assets offering a higher coupon yield than the US treasury bond.
  1. The investor’s portfolio would maintain the same sensitivity to variations in IRR offered by US treasury bonds (modified duration).

 

The duration (sensitivity) of a thirty-year US treasury bond is approximately 18 years, so an 8% investment in this bond would result in a total modified duration of the portfolio of 1.44 years (result of multiplying the 8% exposure by the 18 year duration of the thirty-year US bond). The total modified duration of a portfolio investing 8% in thirty-year US treasury bonds would be 1.44 years, which is equal to that of a portfolio investing 30% in five-year US treasury bonds. The only difference is that the first portfolio would be sensitive to changes in the IRR offered by the thirty-year US treasury bonds and the second would be sensitive to changes in the IRR offered by five-year US treasury bonds.