Treasuries are as risky as emerging market stocks?
Most investors would call me crazy for saying that.
At the very least they’d ask what the ‘catch’ is.
But this is no play on words.
When I say emerging market stocks that’s exactly what I mean… Russia, Brazil, China, South Africa, India, Mexico, Malaysia, Thailand… bonafide emerging markets.
And when I say treasuries, I mean U.S. government bonds… the full faith and credit of Uncle Sam. And with no leverage, before you ask.
So how can these two asset classes possibly be as risky as one another?
Emerging market stocks are widely acknowledged to be one of the most volatile asset classes you can own.
Just look at the performance of MSCI’s emerging market benchmark index in the chart below. It fell by nearly 30% in the 4 months from the end of April to the end of August of this year.
In fact, in the past 5 years emerging markets have experienced corrections of -31%, -20%, -18%, -12%, -17% and -28%…
Before I explain further, let me turn to Vanguard.
Founded in 1975 by Jack Bogle, and with nearly US$3 trillion under management, it’s one of the pre-eminent global fund management companies.
Vanguard offers a suite of very low-cost ETFs, across a range of asset classes.
In trying to assist individual investors, the company designates a ‘Risk Level’ to each ETF.
All ETFs are categorized from 1 through 5. With 1 being the least risky and 5 being the riskiest.
First let’s look at Vanguard’s FTSE Emerging Markets ETF (VWO).
With roughly US$37 billion of assets, its top 5 country allocations are as follow: China, Taiwan, India, South Africa & Brazil.
Not surprisingly, Vanguard rate this as a Risk level 5 ETF.
Now let’s take a look at one of their U.S. treasury ETFs for comparison.
The ticker is EDV.
As I mentioned, it is composed purely of U.S. Government bonds. It currently holds 73 of them.
It’s pretty cheap as well, charging an annual expense ratio of 0.12%.
And it’s designated by Vanguard as a Risk level 5 ETF… the highest possible.
Because it’s the Vanguard Extended Duration Treasury ETF (EDV US).
This ETF holds “Separate Trading of Registered Interest and Principal of Securities”, otherwise known as STRIPS.
First introduced in 1985, STRIPS are U.S. treasury bonds that have carved out the interest and principal payments into individually tradeable securities.
For example, a 30-year treasury can be broken down into 60 semi-annual interest payments, and a single principal payment at maturity.
STRIPS are zero-coupon bonds. And what Vanguards Extended Duration Treasury ETF does is focus on long-dated zero-coupon bonds (STRIPS).
The truth is most investors simply don’t spend much time on fixed income (i.e. bonds) at all.
How much airtime do CNBC and Bloomberg devote to fixed income versus the equity market? It’s fractional.
As a result, from our experience at Churchouse Publishing, a large number of readers don’t have good understanding of fixed income risk.
Now credit risk is easy enough to understand.
We intrinsically understand the difference between lending to the U.S. government by buying their bonds, versus buying those issued by say an Australian mining company.
But when it comes to interest rate risk, things become a little less clear.
The duration of your bond portfolio is a key determinant of how much risk you’re exposed to.
Duration is measured in years, and this number provides you with the approximate change in price of a bond for a given change in interest rates.
If your bond duration is 5 years and interest rates rise by 1%, the price of the bond falls by approximately 5% (and vice versa).
The duration of say the iShares 7-10 Year Treasury Bond ETF (IEF US) is around 7.55.
And the Vanguard Extended Duration Treasury ETF (EDV US)?
The duration is 24.7.
So for every 1% move in interest rates, you can expect roughly a 25% price move in your ETF.
That’s why a portfolio of U.S. treasuries can be just as risky as emerging market stocks.
With the fed likely to start raising rates soon, it’s worthwhile checking out the duration of your fixed income portfolio and making sure you know how much interest rate risk you have on the table.