Must-know: Investing in US Treasuries—return drivers

Phalguni Soni

Must-know: US Treasury markets in the week ending August 22 (Part 2 of 9)

(Continued from Part 1)

Key return drivers for US Treasuries

Treasuries have very low default risk because they’re backed by the full faith and credit of the U.S. government. Most Treasury securities—notes and bonds—pay a coupon on the face value. Others—like Treasury bills—are issued at a discount to face value. They’re redeemed at par.

Impact of overseas demand

Overseas investors are major demand drivers. Geopolitical turmoil abroad usually sees international investors flock to these safe-haven assets. Foreign countries—for example, major oil-producing countries—typically invest part of their export earnings in Treasuries. This year, returns on Treasuries have benefited from demand overseas. Tensions in Russia-Ukraine and the Middle East have increased the demand.

Economic growth hiccups

Negative U.S. economic growth in 1Q14 was another key demand driver for Treasuries. Flagging growth or a downturn in the economy increases risk perceptions in financial markets. This usually results in increased demand for Treasuries. This causes their prices to increase. A decline in demand would lower prices.

In 2014, Treasuries have benefited from these factors. The graph above compares the performance of Treasury exchange-traded funds (or ETFs) like the iShares 20+ Year Treasury Bond ETF (TLT), the iShares 7–10 Year Treasury Bond ETF (IEF), and the ProShares Ultra 7-10 Year Treasury ETF (UST), with the SPDR S&P 500 Index (SPY) and the SPDR Barclays Capital High Yield Bond ETF (JNK).

Impact of the Fed’s monetary policy stance

The most important driver for Treasury yields is the Fed’s monetary policy. The Fed has kept the federal funds rate at near zero levels since December 2008. It’s also embarked on three rounds of quantitative easing (or QE). QE, or its bond buying program consisting of Treasuries and mortgage-backed securities, has increased market liquidity. These factors have led to a falling yields environment over the past few years. This has benefited bond prices.

Can this performance continue?

The Fed recently released the minutes of its latest Federal Open Market Committee (or FOMC) meeting. The next part in the series will discuss the implications for yields and returns in Treasuries market.

Continue to Part 3

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