You’re probably familiar with the inverted yield curve.
The TV talkers and financial press are aflutter with the phenomenon, and it’s become part of the investment vernacular for even the most casual bond market observers.
What’s missing in this discussion, however, is clear-eyed thinking on its long-term implications.
For starters: An inverted yield curve is formed when, contrary to the norm, yields offered on short-term money market securities are higher than long-term bond yields. At the time of this writing, the yield on 30-year Treasury bonds is below 4.50%, while two-year notes yield 4.68%. When the yield curve is “normal,” the 30-year Treasury bond yield is typically more than 2 full percentage points (200 basis points) above the two-year note rate.
Under normal circumstances, bond buyers expect the rate of return on debt instruments to increase in direct proportion to the time the money will be invested (maturity date). Theoretically, longer-term bond investors should earn higher returns for taking on increased volatility and market risk
BEYOND THE CURVE
So why are sophisticated investors now buying longer-term bonds and accepting lower yields with more market risk?
We think it’s because they have good memories.
Market participants remember prior periods of Fed tightening and believe that the Fed will continue to raise short-term rates until the economy slows and inflation is not perceived to be a threat.
Since we expect further inversion of the yield curve, we suspect that some fixed-income investors, enticed by higher rates on shorter-term money market instruments, may abandon what has been a successful strategy of maximizing income by buying long-term bonds.
POTENTIAL TRAP
We are concerned that by shifting income-producing investment dollars to the short end of the market, investors may be unwittingly exposing themselves to “income risk.”
The most glaring example of this occurred in the early 1980s, immediately after Paul Volker was appointed Fed chairman. He began to push up short-term rates in an effort to stamp out the inflation that was undermining the U.S. economy. Consequently, the yield curve became dramatically inverted. Short-term bank CDs returned more than 20%, while long-term Treasuries yielded 14%.
Many investors mesmerized by short-term yields in the 20% range made the mistake of buying this shorter-term paper. Others eschewed these higher short-term rates because they afforded no “call protection” (income protection).
SHORT-SIGHTED
As higher short rates pushed the economy into recession, long-term buyers proved to be correct. In the ensuing years, short-term rates dropped to 5% while 30-year bond yields declined precipitously.
Investors who delighted in receiving higher short-term rates were chagrined to find that when their CDs came due and money market returns plummeted, higher yields on long-term bonds were no longer available. Long-term municipal bond buyers got the last laugh, enjoying historically high rates, which were call protected for the next 10 years.
Be forewarned: Short-term rates will move higher than most people expect. However, we recommend staying the course. Take advantage of long-term, high quality, tax-free bonds yielding between 4.50% and 5.00%. Anytime an investor can purchase AAA tax-free bonds with the same or higher yield than the 30-year Treasury bond, it has proven to be a rewarding investment.
Remember: Inverted yield curves are rare and shouldn’t be ignored. They are invariably followed by an economic slowdown or recession. Either scenario will lead to lower interest rates across the board.
