Bonds #19: Reading Yield Curves
Last week, we got into some nitty-gritty investment lingo that should take some of the mystery out of interest rates. Hopefully, it will help you when it is time to make the decision to buy a 3-month CD, a 2-year Treasury or a 10-year bond.
As in most fields, investment professionals develop their own “shorthand" for their work. But once you decipher the jargon, the concepts themselves are generally common sense.
Last week, we defined a “yield curve” as:
a graph of the different interest rates earned by Treasury bonds that mature at different points in time.
And we saw that the curve could slope upwards, illustrating that you would earn a higher rate if you tied up your money for a longer time.
In investment jargon, this translates into:
“With a positive slope on the yield curve, yields increase as duration extends.” Don’t be intimidated.
It looked like this:
Highest rates X
X
Medium rates X
X
Low rates X
X
Cash < Short < Medium < Long term maturities
As we said, this is a fairly common situation, and is called a “normal curve.” It assumes a “normal” rate of inflation (about 2½%) and pays you more because the buying power of your investment will decrease somewhat from inflation as time goes on.
It also pays you more for taking on the additional “market risk” (fluctuation in price) that a longer-term investment will have. This would be a concern only if you were forced to sell the investment before its maturity date.
If the yield curve is flat, (illustrated last week) longer-term investments don’t pay you much more than short term ones.
Why? There is still “market risk.”
Over time, there will probably be some inflation, too.
So, why?
The “curve” is a reflection of supply and demand.
If the marketplace is worried about high inflation in the years ahead, longer-term bonds will be less popular. Like everything else, as demand decreases, the prices go down. This makes the yields go up. (Remember, prices and yields on bonds move like the opposite ends of a seesaw).
So, a flat curve can tell us that the marketplace is forecasting low inflation.
It can also tell us that long-term bonds are in demand, pushing the price up, and holding yields down.
Why would they be so popular? Because the market thinks that interest rates are going down, and they better jump in and buy bonds at today’s levels while they can.
This sort of interest-rate forecasting is a tricky business, and professionals on Wall Street are happy if they are right 51% of the time. Beating the odds is dependent on so many factors! A few are: economic developments, Federal Reserve actions, currency crises overseas -- even the weather, since it affects crop prices!
In general, I believe that investors who buy bonds for income and who don’t want to trade actively should take the highest yield they can, given the investments they already own and their investment objectives.
If you have a “ladder” of maturity dates for your bonds, and the yield curve is “normal” then buy the longest bond that fits your maturity range.
For instance, say that your investment range is from 1 to 10 years, and your longest bond matures in 9+ years. Go ahead and buy a bond that matures in 10 years. The yield will be higher than a shorter-term investment, and it fits your plan. Most times, as cash accumulates or your short-term bonds mature, this will be the reasonable decision.
Next time: unusual curves!