Many investors -- myself included -- have only been active investors at a time when Treasury bonds and notes have been practically non-factors. For example, since 2000, the two-year Treasury rate has rarely exceeded a 4% yield. But that changed as of the Treasury note auction on Sept. 30.
2 Year Treasury Rate data by YCharts
This yield may leave many investors (especially those seeking income) wondering if Treasury notes and bonds are worth adding to their portfolios instead of high-yielding dividend stocks.
Treasuries are much more intriguing than they have been for some time, but there are a few things investors must be aware of, as they may not be the best choice in some situations.
Bond basics
First, you need to understand how bonds work. Bonds can be issued by many entities (a city government, a company, or the U.S. government), but investors almost always use U.S. bonds as a starting point to compare risks and returns. Treasury securities are issued to raise money, and the bondholder is paid an interest rate in return for the borrowed money. Essentially, Treasuries pay for the deficit in the U.S. budget.
Although sometimes used interchangeably, a bond and a note are slightly different. Notes mature in more than a year but not more than 10. Bonds mature more than 10 years from the issue date. Besides that, each pays the holder interest every six months until the maturity date, so the difference is purely notational.
Investors can purchase bonds or notes directly from the government, and many brokerages offer this option, so they are easily accessible to many investors. Bonds also can be bought and sold in secondary markets.
Now that the basics are out of the way, let's discuss why you might want to buy them.
Guaranteed income
Unless the U.S. government defaults on its loans (in which case we'd have much bigger problems than making investment decisions), you will always get paid interest from your bond. Additionally, if you hold a bond to maturity, you will get back the money you initially invested.
This guarantee is something that cannot be said about a high-dividend stock like AT&T (T 1.02%). Since 2010, AT&T has averaged about a 7% yield, but its stock price has fallen almost 25% in the past year. So even though you get to keep all of the dividends AT&T has paid, the underlying asset has declined in price. Additionally, AT&T's dividend payout was cut in half in early 2022 after multiple decades of growth.
So despite an alluringly high yield, AT&T ended up hurting investors. However, investors can lose money on Treasuries too.
How is that possible? By selling them before their maturation date. Bonds and note prices fluctuate according to the current yield of new bonds. If the rate is higher on new bonds, then your lower-yielding bond is worth less. On the flip side, if the rate for new bonds is lower, your bond, which has a higher yield, is worth more.
This mechanism is precisely why U.S. Treasury bond indexes are down this year -- no one wants to buy old bonds and notes with rock-bottom yields.
With general market uncertainty, bonds and notes look attractive, as many investors love the idea of guaranteed income without worrying about the underlying asset prices (assuming they hold the Treasury to its maturity date). However, bonds and notes aren't for all investors.
Stocks are better long-term
As stated before, the primary reason for owning a Treasury bond or note is to capture yield without risk. However, one unaccounted-for risk is the lack of real returns. While the two-year note yields more than 4%, the current inflation rate is roughly twice as high. Time will tell if the inflation rate is peaking, but if it isn't, then you're losing money with bonds.
Another consideration is how much stocks outperform bonds over the long term.
| Time Period | Large-Cap Stock Returns | U.S. Long-Term Bond Returns |
|---|---|---|
| October 1929 to Present (Great Depression) | 9.59% | 5.59% |
| October 1987 to Present (Black Monday) | 10.34% | 8.09% |
| March 2000 to Present (Dot Com Bubble) | 7.48% | 6.74% |
| September 2008 to Present (Great Recession) | 10.32% | 5.79% |
Source: Forbes. Returns are average annual returns.
Historically, stocks consistently outperform bonds. Sacrificing upside for stability is something many people do, but if you're trying to maximize your portfolio returns, then bonds don't make as much sense.
If you're looking for yield with growth, many real estate investment trusts (REITs) offer both. Additionally, other businesses like Texas Instruments (3% yield) have paid great dividends, all while crushing the market, something AT&T can't say.
FXNAX Total Return Level data by YCharts
Every investment situation is different, but I think there are much better investments than notes and bonds, despite their alluring yield. Long-term performance isn't on the side of Treasuries, and I think investors should understand that.
However, those nearing or in retirement could consider putting some of their portfolios in Treasuries, especially if the money is needed in the near future.
