Cash Has Been King: When Does It Pay to Take Duration Risk?

Core Insights - The article discusses the optimal maturity decisions for Treasury holdings, emphasizing the importance of real yields and inflation in determining investment strategies [1][6][14] Group 1: Historical Performance of Treasury Securities - Longer-dated maturities have historically provided higher yields and superior real returns, with 10-year Treasury notes yielding 206.96% cumulative real returns since 1961, compared to 113.74% for 2-year notes and 56.43% for 3-month Treasury bills [2][3] - Recent performance has deviated from this trend, with 3-month Treasury bills delivering 5.51% real returns over the past three years, while 10-year notes posted -5.70% [4][5] Group 2: Real Yields and Duration Decisions - Real yields have shifted, with 3-month bills currently offering the highest real yields at 1.05%, compared to 0.56% for 2-year notes and 0.34% for 10-year notes, indicating a reversal in the traditional risk-return relationship [7][8] - The article suggests that when real yields are higher for shorter maturities, the rationale for extending duration diminishes, as investors are better compensated for staying short [8][14] Group 3: Inflation's Impact on Treasury Bill Returns - Inflation is identified as the primary driver of Treasury bill real returns, with positive real returns occurring when Treasury bill rates exceed inflation [10] - The article highlights that Treasury bills performed poorly during high-inflation periods when nominal rates lagged behind inflation, emphasizing the need for investors to monitor inflation expectations [10][11] Group 4: Yield Curve Dynamics - The shape of the yield curve provides additional insights, with Treasury bill real returns averaging 0.11% when 2-year yields exceed 3-month rates, but only 0.05% when the curve is flat or inverted [11][12] - The article notes that the yield curve's shape offers minimal guidance for extending from Treasury bills to 2-year notes, suggesting that decisions should be based on absolute real yields and broader portfolio considerations [13][14] Group 5: Strategic Implications - In the current environment, with positive real yields of approximately 1.23% on Treasury bills, the inflation factor strongly favors short-term positioning [17] - Should the Federal Reserve push Treasury bill rates into negative real yield territory, investors may need to consider moving further out the yield curve to capture positive real yields [18]