Why the G Fund is Special

This article details the outstanding aspects of investment in the G Fund, and particularly how bond portfolio performance, considering the effects of duration, volatility, and return, can be significantly improved when the G Fund is part of a bond portfolio.

The G Fund is a unique Treasury security offered exclusively to U.S. Government employees and military members. The fund is a unique part of the Thrift Savings Plan (TSP),  a 401K-type retirement program.  There is an equivalent also available to investors using the new MyRA.  Investors in the TSP enjoy some of the lowest expenses in the industry, an amazing 0.029% expense ratio for every fund.

The G Fund makes it even better because it can never fall in price, yet it earns a rate of interest equal to:

…the weighted average yield of all outstanding Treasury notes and bonds with 4 or more years to maturity. As a result, participants who invest in the G Fund are rewarded with a long-term rate on what is essentially a short-term security.

Since the G Fund has unique and desirable qualities, any investor who has access to the TSP should include the G Fund as part of the bond portfolio.  It is a rare free lunch. I have read quite a few questions from people trying to figure out how to classify the G Fund within the portfolio. In short, you can approximate the volatility and returns of intermediate treasuries by using a combination of G Fund, intermediate, and long-term treasuries.  Best of all, you can add the benefit of a slightly higher duration and yield, yet with similar volatility to intermediates.

Traditional bond portfolios are typically structured to emphasize high quality, and at an intermediate duration.  ^a)Quality is a reference to credit risk, and specifically default risk.  Default risk is the possibility that a company declares bankruptcy or a municipality becomes insolvent, and cannot pay in a timely manner the principal and interest payment it owes under a bond indenture.  Duration is a reference to interest rate risk.  The longer the holding period of the bond, the more current market prices affected when current interest rates change.  More on the subject of bonds in general can be found here. The G Fund has no credit risk since it is a treasury security, and it has no duration risk since it can never go down in price, only up.  For this reason, the G Fund’s duration is zero.  ^b)The Vanguard Intermediate Treasury Fund has an average duration of 5.3 years.  The practical application of that duration is that if interest rates were to rise by 1%, a bond fund with a duration of 5 years could be expected to fall in price by about 5%. The G Fund has zero duration since, no matter what happens to interest rates, it can never fall in price.

The point is that, when including the G Fund, duration can be increased in the bond portfolio for a greater expected return yet with similar volatility.  The total return chart ^c)Depending on the period measured, you will get different results. The point of the charts is to illustrate the relationship between returns of two portfolios and associated volatility below shows the performance of Vanguard Intermediate Treasury Fund versus a combination of 55% G Fund, 10% Intermediate Treasury (VFITX), and 35% Long Term Treasury (VUSUX) since 6/2/2003^d)This start date is used because it is the starting date I found for the G Fund data. . The combination currently yields 2.45% versus 1.54% for VFITX. Duration for the combination is slightly higher, at 6.3 years:

Yet, while duration is higher by one year, the maximum monthly volatility is about the same; neither exceeds 2.5% for the period measured, a period that includes some of the most volatile bond market conditions since the 1970s.

Note that the intermediate treasuries have been more volatile since mid-2007, and since mid-2011, our combination example, which includes long-term treasuries, has been more volatile than intermediates. Before the housing/financial meltdown of 2008, the combination was less volatile than intermediates.

Using the weights in the above example, a combination such as this can be classified as “intermediate treasuries” in a bond portfolio.  While there will certainly be some tracking error when compared with intermediates, it will make little to no difference at the portfolio level.  I developed this mix to illustrate you can approximate or slightly exceed the performance of intermediates, but with a higher yield and similar volatility.

This is what makes the G Fund special.