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As Safe As It Gets

December 26, 2018

The S&P 500 Index is down 16.98% since the end of September. If the last three trading days in 2018 don’t move the needle, we’ll see the S&P finish 2018 down 9.54%. This makes for an even stronger case to focus on income for your own portfolios. But one of the challenges for 2018 has been expectations for higher interest rates. That’s been fueled by the Federal Reserve Bank and its Open Market Committee (FOMC) in its drive to raise the target range for the fed funds rate.

The FOMC has raised its target rate range from the low 1% range into the mid 2% range. It’s uncertain if and when the Fed may settle down on hikes to the range as well as its open-market operations to influence short-term interest rates for banks and relevant financials.

This has come with some wild overreactions in parts of the bond market, particularly earlier in 2018, which caused similar knee-jerk reactions in dividend and yield-focused stocks and other investments.

The results were largely seen in the first quarter of the year, as many dividend-focused stocks and funds were pummeled, sending many sectors to lows in February. Now, many of those same sectors and the related stocks and funds have since come back and even risen during the year, including during the general stock market sell-off from October into December.

This is leading to most investors wanting and needing a refuge for some of their portfolio. But rather than just parking cash, there must be some other alternatives that offer more yield while also providing liquidity and top tier safety.

Let me introduce you to my friend Mr. Two-Year.

Treasuries are the benchmark for the US bond market as well as for the global US-dollar-denominated bond market. They are issued to fund Uncle Sam’s never-ending spending as well as to serve the needs of entitlement and programs including for the US Treasury. And while there is an argument that the US government’s credit isn’t what it used to be and that ratings should be lower than they are, Treasuries are still considered risk-free, as the government can always run the printing presses to service the debt that Treasuries represent.

Right now, the two-year Treasury is yielding 2.59%. This yield represents the bulk of the yield offered in the Treasury market, from the three-month at 2.43%, the 10-year running at 2.78% and the 30-year topping out at 3.04%.

And that makes for a pretty good yield right now, given that we have low inflation, with the core personal consumption expenditure index (PCE) sitting at 1.8% and little expectation among market-watchers that we’ll see it significantly rise..

Yield curve shifts in 2018 saw shorter-term yields rise against longer-term maturities. These shifts weren’t about inflation or growth. Instead, the Treasury had to issue more bonds in light of the impact to the Federal budget from the Tax Cuts & Jobs Act of 2017 (TCJA). The Act caused some revenue shortfalls that had to be made up with Treasury bonds. The Treasury it issued more in the short-to-intermediate area of the yield curve, driving up supply, and yields rose in the process.

With the stock market mayhem, longer-term bonds found more buyers, driving down yields and driving up prices.

This has impacted the two-year Treasury. Yields went from 1.93% at the start of 2018 to a high in November of 2.97%, and back down to a current 2.59%. That’s a pretty big upward shift in yield, bringing the two-year into what I see as the sweet spot for the yield curve.

With the bias for rates for longer bonds to fall for now, the two-year is well defended in its current price. Moreover, there is plenty of room for the two-year Treasury, bought now, to roll down the curve, bringing its yield lower with each day owned as its maturity gets shorter over the holding period. This means the price risk is limited.

In short, the two-year Treasury makes for a great low-risk parking place with yield for some of the can’t-lose assets in your portfolio.

To buy a two-year Treasury bill, all you have to do is to call or search your brokerage’s website for the maturity. The brokerage will show you available Treasuries with approximate maturities of around two years. The only caveat is to instruct the brokerage to sell you a two-year with a coupon (the stated interest rate) that is close to the current yield, which is now at 2.59%.

Nominal commission fees will make this an inexpensive transaction. And the two-year will provide nice income that provides a risk-off option for part of your portfolio as we head into 2019.