The 10-Year Treasury Yield Just Hit 5%, and It Creates a Dilemma S&P 500 Investors Haven't Faced in Nearly 20 Years

Just five years ago, the Fed Funds rate was 0%. Three-month Treasury bills were yielding 0.05%. Even the 10-year Treasury yield was a meager 1.5%.

Needless to say, the bond market offered very little to income seekers unless you were willing to venture out into risky longer-term junk bonds. Worse yet, yields had almost nowhere to go but up from there, making eventual losses a high likelihood.

Today, the fixed-income environment is different. It took some pain to get there, but bonds offer a legitimate risk/reward consideration when compared to stocks. The 10-year Treasury yield just crossed the 5% threshold for the first time since 2007, meaning investors can lock in a (theoretically) risk-free yield of 5% annually for the next decade.

And that poses an interesting conundrum for investors. Do you buy a 10-year Treasury bond, take the 5% yield, and call it a day? Or do you choose the S&P 500 (SNPINDEX: ^GSPC), assume the volatility that comes with it, and try to capture a higher return?

Several years ago, the choice would have been easy. Today? Not so much.

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A 5% Treasury yield changes the situation

The appeal of buying a Treasury is that you know the return you're going to get.

For example, if you buy a $10,000 10-year Treasury note at par value with an interest rate of 5%, you know that you'll collect $500 annually in each of the next 10 years. That's assuming you hold the bond until maturity and get your $10,000 back. These bonds, however, fluctuate in value, which means if you sell at some point along the way, what you can sell that bond for may generate a capital gain or loss.

Now compare that effectively guaranteed 5% annual return with a similar investment in the S&P 500. Over the long term, the index has generated a roughly 10% average annual return. In absolute terms, that would seemingly favor investing in stocks over bonds, but there are two things to consider:

• There's no guarantee the S&P 500 will generate a 10% annual return or even anywhere close to that.
• Even if it does, stocks come with higher volatility and an unknown risk/reward trade-off.

In Let's Make A Deal, that's the equivalent of choosing door No. 1, which has a known 5% annual return, or door No. 2, which could have a new car or it could have a donkey. That's the risk you're taking.

Should investors choose the S&P 500 or long-term Treasuries?

There's no one-size-fits-all answer to this question. But we do know there are a couple of factors to consider:

• Those with long-term time horizons of 10-plus years should generally favor investing in stocks over bonds. Investors who'll need the money in less than 10 years might want to focus on principal preservation instead of maximizing total return.
• Over the next decade, the S&P 500 is likely to experience multiple corrections of 10%, 20%, or more. If that idea makes you uncomfortable, the comparative safety of Treasuries might be more attractive.

If you don't like the downside risk of stocks or locking your money up with a 10-year bond, there's another option: Treasury bills.

The iShares 0-3 Month Treasury Bill ETF (NYSE: SGOV) currently yields 3.6%. And it comes with complete flexibility to buy and sell at any time with very little share price fluctuation. You give up some yield compared to a 10-year Treasury, but that might be worth it to you, depending on your risk tolerance.

Personally, I still have a 10-plus year time horizon, so I'll be sticking with equities. But a 5% yield as an alternative did make me pause and think for a moment. I'm still choosing the long-term growth story. But for income seekers looking for more certainty, today's 5% yields on long-term Treasuries are certainly a compelling alternative.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends iShares Trust-iShares 0-3 Month Treasury Bond ETF. The Motley Fool has a disclosure policy.