By: Investor Solutions
Interest rates, bond yields, bond prices and inflation are all interrelated and they all help to shape what’s called the yield curve. The yield curve is what we use to capture overall movements of interest rates between various maturities for a given instrument (usually US Treasuries). A living yield curve traces those rates over time. It’s important to understand the yield curve and what it’s telling you when determining an appropriate fixed income strategy. The four different types of curves (flat, steep, normal, inverted) are said to predict different things and historically have been fairly accurate. The current yield curve is below.
This curve is referred to as a steep curve and usually occurs when people believe we are in the midst of an economic expansion, usually just after the end of a recession. That is the case now and back in 2002 after the dot.com crash.
A normal curve is just that, normal and it occurs most often. It looks just like the steep curve but with a smaller rise over run. The reason for a curve shaped like this is because investors demand more return (higher interest rate) for lending their money over a longer period of time. The graph goes from the shortest maturity, 3 months (left), to the longest maturity, 30 years (right), and then lowest interest rate (bottom) to highest (top). This generally occurs when the market expects the economy to grow at normal rates without inflation worries or changes in monetary supply.
An inverted yield curve occurs when long term yields fall below short term yields causing a downward sloping line. This means that long term investors will settle for a lower yield because they believe rates will decline in the future. An inverted curve usually forecasts an economic slowdown which will cause the Fed to ease its money supply. It also may occur in times of deflation when current cash flows are less valuable than future cash flows increasing the demand for longer term bonds and driving up their price while decreasing their yield.
When a flat curve is present investors have no incentive to invest in longer term bonds because anything further out on the curve is uncompensated risk. A flat curve is a signal of indifference or uncertainty in the economy. The general idea is when interest rates are rising you want to stay in short duration bonds and when interest rates are decreasing you want to lock in a long term bond. Lower expected rates will cause the curve to be inverted while higher rates will shape a normal curve.
However these are all speculative plays and the best position to be in is where there is the most reward for each additional unit of risk. You would find that spot on the steepest point of the curve. In the graph above that point is right around four years. Fund managers monitor that point each day, as the curve reshapes itself, to get the optimal yield available. This optimal point is usually fairly short term which makes sense. With short term risk you have less default risk.
In the grand scheme of things, though, there’s more to prudent investing. First and foremost don’t risk your capital on low quality or long term fixed income. Why take that risk when you could shift it elsewhere? The equity markets have historically outperformed the bonds markets. Take your chances there, you have better expected returns. Use your bond portfolio as your safety net and keep your duration short term as the yield curve shows.
In this environment many people have lost value in their fixed income portfolio. This is truer with longer term bonds as they are more volatile than short term bonds as risk and rates change. The general thought is to hold on, because if you make it to maturity you will get your interest and full principle returned. However, you are giving up an opportunity cost. With rates having no place to go but up, future short term rates could easily surpass the current long term rates. Instead of hanging on to that 15 year 4% interest with principle you’re trying to recoup, you should invest in a 3 year 2% bond and as interest rates increase roll over your maturity into a new short term bond with higher rates and less risk. This allows you to avoid missing the opportunity (reinvestment risk) of investing in a bond with a higher rate because you were locked into a long term bond. The best strategy is to stay in high quality, short term fixed income (less than 5 years) and let your equity position bear the risk of your portfolio. The stock market has always rebounded and outperformed fixed income. If you are diversified across many asset classes your portfolio will be less risky than the risk associated with high yield bonds.