A pillar of Risk Parity portfolios, Long-term Treasury Bonds provide positive expected return, some income, and most importantly, negative correlation with equity funds. To invest in them, I use Vanguard’s low-cost, no-frills Long-term Treasury ETF (VGLT), though alternatives such as TLT, SPTL, and EDV are also great choices.
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Long-term bonds are a good example of a key principle of Risk Parity: two risky assets, when combined, can lead to lower risk than either by itself, as long as the risks are negatively correlated with each other. In Risk Parity portfolios, Long-term bonds are not the choice even though they are risky; LT bonds are the choice precisely because they are risky, and risky in a different way than equities. Risk Parity investors are on the lookout for the “Holy Grail” of investing: multiple streams of assets whose risks are uncorrelated, or better yet, negatively correlated with each other. Although they often get a bad rap, Long-term Treasuries are the best way to diversify against the main driver of returns in your portfolio: stocks, all while delivering positive returns themselves.
Long-term Treasuries often get that bad rap because they can plunge suddenly when the Federal Reserve raises interest rates. Without getting too much into the weeds, the prices of bonds on the secondary market fall when rates on brand-new bonds rise, and vice versa. This makes some investors very uncomfortable, since an announcement from an economist in Washington can send the price of bonds they hold down by 10% (or more) practically instantaneously.
The key concept with bonds that is worth paying attention to is duration - which is a measure of a bond’s sensitivity to future rate changes. The higher the number, the more a bond’s price would be expected to move (up or down) if there were a 1% move in the Fed’s interest rate. Duration is not exactly the same as term, though the term (1 year, 5 year, 20 year, whatever) does factor into the calculation of duration, in addition to interest rate, yield, and credit quality. For our purposes, it is enough to know that Long-term Treasuries have a longer duration than intermediate or short-term, and we can therefore expect them to move more dramatically when a change in interest rates is announced. As mentioned, this is a good thing.
As for the particular fund to capture this price movement, I use Vanguard’s version VGLT. Below, I compare VGLT to some competitors, and truth be told, they are all good. Vanguard does have the lowest expense ratio in its class (.04%), but I would guess that my choice of VGLT in the test portfolios is really just because of consistency. When faced with multiple versions of the same thing, I default to Vanguard.
Correlation with Other Assets: Link to Correlation Matrix
The foundational pairing in Risk Parity is between stocks and Long-term Treasuries, as these typically give you the greatest degree of negative correlation you can get while still having positive expected returns. The correlation matrix shows high degrees of negative correlation between SPY and TLT, slightly higher than the Intermediate-term Treasuries/equities pairing, and just a smidge lower than the Extended Duration Treasuries/equities pairing (see below for more on Extended Duration bonds)..
The different different types of bonds also distinguish themselves in terms of annualized return. Longer term bonds often (but not always) pay out more than shorter term bonds, for the simple reason that the bondholder has locked their money for a longer period of time.
Two competitors for VGLT are iShares’s TLT and State Street’s SPTL. These are far all intents and purposes the same as VGLT, though they do have higher expense ratios (.15% and .06%, respectively, compared to VGLT’s .04%). You could also invest in the same Long-term Treasuries in mutual fund form, either with Vanguard’s VLGSX, or even better, Fidelity’s FNBGX, which has a lower expense ratio (.03% compared to .06%).
Vanguard’s Extended Duration Treasury ETF, EDV, is like VGLT on steroids, with its sensitivity to price changes dialed up a bit. Whereas the duration for VGLT is usually around 18 or 19, EDV’s duration is close to 25, leading to more price sensitivity. This means that EDV is more negatively correlated to equities than even TLT (though just by slightly in the correlation matrix above), and has higher expected returns, too. EDV is a great fund, but is better in tax-advantaged accounts: it usually produces more in distributions than Long-term Treasuries and its higher volatility is easier to manage in a tax-advantaged account.
If EDV is VGLT dialed up to 11, then TMF is VGLT dialed up to about 30. This is an ETF that uses various derivatives to pursue returns that will be three times that of TLT, for good or bad. It is an embedded leverage fund, similar to UPRO on the equity side, and is also featured in several test portfolios, including the Levered Butterfly and Levered Seasons. Investors should be aware of the inherent risks of embedded leverage ETFs, though, and not jump into this one willy-nilly.
Do NOT get fooled by various Long-term bond funds if they don’t specify that they are funds of Treasuries. These are usually heavy in corporate bonds, which are a whole different kettle of fish. BLV, Vanguard’s Long Term Bond Fund, is 44% Treasuries and 56% Corporate Bonds, so it really is quite different than the 100% allocation to Treasuries in VGLT. At first glance, there are some advantages to corporate bond funds, or bond funds that include corporates, namey, a higher yield. They can be seductive to investors who look at yield, or the interest rates that bonds pay.
But, and this is a crucial but, for adherents to Risk Parity concepts, the yield of bonds is secondary, and corporate bonds are substantially worse at performing their primary role in a Risk Parity portfolio, which is to zig when stocks zag. At times when your stocks are declining, your corporate bonds will tend to move with them because they are responding to the same source of risk, which is that people are wary of investing in companies, whether it be equity or debt. In the correlation matrix above, you can see that the various forms of Treasuries are all lower than -.3 when compared with the S&P 500, while BND is above zero and the corporate bond fund SPBO is all the way up at +.32. For Risk Parity portfolios, stick with Treasuries… the longer the duration, the better!
Meanwhile, if you're keen, here is a link for my search of "Treasury Bond " funds using the ETF Finder on Barchart. You’ll notice that bond funds of different maturities are listed: