Treasuries remain one of the safest investments because they're backed by the full faith and credit of the United States government. That makes them attractive to skittish investors during a down market. The problem is that treasury yields are near historic lows. And interest rates have nowhere to go but up, which doesn't bode well for longer-term treasuries. Here are four reasons why you should diversify your portfolio outside of treasuries:
Sooner or later, interest rates will rise. The Federal Reserve has kept the target range for the federal funds rate (the interest rate at which banks lend to each other) between zero and 0.25 percent since December 2008 and has, since March 2009, repeated its pledge to keep rates low for an "extended period." When rates finally rise, investments like treasuries will be negatively affected. When interest rates go up, the price of existing bonds will go down. "The irony is that if interest rates do go back up—and there's no sign they're going to for quite a while—but if they do, 10-year and 30-year bonds aren't going to be a bargain at all," says Brian Gendreau, market strategist with Financial Network. "People forget that when the Fed tightened [rates] in 1994, the 30-year bond lost 27 percent of its value." Gendreau believes that interest rate hikes are at least a year away, but he cautions that once the Fed believes it's time to raise rates, many investors will see losses in the principal of the bonds that they're holding.
Yields are at historic lows. The yield on a two-year treasury is currently 0.49 percent, and the 10-year treasury only yields 2.62 percent. Gendreau says investors not being paid enough for the risks (like the threat of interest-rate hikes) of investing in a 10-year treasury right now. Yields have historically been much higher. In mid-2007 when economic growth was much more robust and demand for treasuries was much lower, 10-year treasuries were yielding as much as 5 percent. "Yields are really so low that they're not attractive," Gendreau says.
Stocks are yielding much higher. So far this year, investors have shunned stocks. As of the end of July, investors have pulled more than $5 billion out of domestic stock funds, while domestic bond funds have seen inflows of more than $165 billion, according to Morningstar. Yield-seeking investors may want to consider allocating some of their portfolio to stocks that pay dividends. Stocks are inherently riskier than bonds, but in the current market environment, Gendreau says most investors are overlooking the attractiveness of some stocks. Dividend-paying stocks provide investors with income and also the potential for capital appreciation (if a stock goes up in value over time). There are a number of dividend-paying stocks that are yielding more than many fixed-income investments. "[Stock] yields are really quite high by historical standards," Gendreau says. He recommends that investors look to sectors like healthcare, utilities, and financial services companies for strong dividend payers. Not comfortable picking your own stocks? Leave it to the experts. There are plenty of stock funds that offer attractive dividend yields. Take Cullen High Dividend Equity, which is among U.S. News's top-ranked large-value funds. The fund yields 2.37 percent. If you prefer exchange-traded funds, there are many low-cost options that are available to investors. One is Vanguard Dividend Appreciation ETF, which yields 2.02.
[For more options, see 7 Great Dividend Funds.]
It can happen fast. The bond market can change quickly. Gendreau says the Fed won't raise rates until there are some signs of inflationary pressure, but once inflation is perceived to be a real threat, the Fed may make quick moves to contain it. "Interest rates are close to zero. ... No one thinks that's sustainable," Gendreau says. "Everyone is going to be looking ahead to the day when the Fed starts to hike rates, to basically raise them to more normal levels." He cautions that once the Fed believes it's time to raise rates, investors could see a trend of steadily increasing interest rates. That's why it's important to be diversified in the bond portion of your portfolio, among various asset classes like corporate bonds and treasuries—so when rates go up, your portfolio doesn't take a big hit.