Treasury Yield Curve (The 'Core' Portfolio)

March 04, 2008

Comparing any investment to its risk-free version can reveal its intrinsic value.


The intrinsic value of any investment should be based on its relative risk/reward to the risk-free portfolio ... the Treasury yield curve. When William Sharpe, Ph.D., invented his Sharpe Ratio in the 1960s, he suggested that all investments be compared to the shortest Treasury (i.e., 3-month T-Bill) as the risk-free rate. After meeting with Professor Sharpe in 1994, he realized and agreed with me that risk is not a generic measurement but relative to the objective and time horizon. He proceeded to write a paper titled "Sharpe Ratio" in the Journal of Portfolio Management in the fall of 1994 explaining in detail his views and recommended his new Sharpe Ratio, which is more commonly named as the Information Ratio.

With the advent of Treasury STRIPS (Separate Trading of Registered Income and Principal Securities) in 1985, a yield curve of zero-coupon bonds was now investable. My team and I created the first Treasury STRIPS indexes as a yield curve of 30 distinct annual index maturities the day after STRIPS were born. Over any investment horizon, the Treasury STRIPS with a maturity equal to the investment horizon should be the risk-free security since it has a known and certain future value (no risk). Virtually no other investment knows with certainty its future value and thus is risky. To ascertain the amount of risk and the value added or lost (i.e., reward) of each asset class or investment, you need to compare each investment to the Treasury STRIPS yield curve. For asset allocation purposes, the Treasury STRIPS yield curve should be viewed as the Core portfolio that every asset class is compared to. The asset allocation decision is whether each asset class has enough value added versus the Treasury STRIPS yield curve to warrant investment. Why should you invest in that asset class if its relative risk/reward isn't sufficient? Bonds are a simple example of relative value. If the yield spread versus the same maturity or duration Treasury STRIPS is too low, most bond investors will buy the Treasury instead. This should be a similar procedure for every other asset class investment.


Most asset allocation models use the Lehman Aggregate as their benchmark for bonds. As a result, the risk/reward behavior of this index dictates the asset allocation towards bonds. When compared to the Treasury STRIPS yield curve with the same or similar duration, it should reveal the relative risk/reward of this index behavior. Surprisingly, this index heavily skewed to non-Treasuries (no Treasury STRIPS issues in the index) has significantly underperformed the Treasury STRIPS yield curve over the last 10 and 20 years. The Lehman Aggregate consistently reports an average duration between 4.00 to 5.00 years. When compared to the Ryan 5-year STRIPS Index, the Lehman Aggregate loses by -0.58% annually over the last 10 years and by -0.45% over the last 20 years. When compared to the Ryan 4-year STRIPS, the Lehman Aggregate loses by -0.13% annually over 10 years and wins by only 0.17% annually over 20 years. These return comparisons are before taxes. Since Treasuries are exempt from state and city taxes, this would add about 20 to 40 basis points of annual return even at today's low yields. This historical return comparison should prove that yield is not return as so many investors are persuaded by the yield of bonds in deciding whether to buy bonds and which ones. Treasuries are usually considered the least desirable bonds due to their lower yields.


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