Bonds #20: Unusual Curves!

38-24-36—no, that’s NOT the kind of curves I meant!

This is not a Mae West lookalike contest, but an article about bond yield curves. This is about making INTEREST on your MONEY, not the other way around!

Get with the 21^st century!

Okay, back to business. The business of picking a maturity date for your bond investment, and making the most of your investment strategy. You can find the best return by looking at the yield curve.

NORMAL CURVES

A normal, upward sloping curve shows that you will earn more interest if you buy a bond with a longer maturity date. After all, you should get paid more if you tie up you money for a longer time. Shorter-term bonds, with their lower risk, give you less yield. So far, this isn’t rocket science!

FLAT CURVES

Last week, we saw that a flatter curve gave you less of a bonus for investing longer-term than usual. This shape occurs when buying pressure drives up the price of the longer-term issues, pushing down the yield on the investment. (Either everyone wanted to buy long-term bonds at an attractive yield, or there was a scarcity of long-term bonds, and this made them expensive.) Either way, you are not getting paid for taking additional risk, so you would generally be wiser to buy the less risky (shorter-term) bond and get paid about the same.

STEPPED CURVES

Sometimes, the “yield curve” looks more like steps. In these cases, it makes sense to buy the shortest bond that pays you a particular interest rate.

Here’s one scenario:

7.0%

6.5%

6.0% X X

5.5% X X X X X

5.0%

4.5% X

4.0% X

3.0% X

2.0%

1.0%

0

years 1 2 3 4 5 6 7 8 9 10 20 30

What bond would YOU buy????

For my portfolio of bonds, I’d buy a bond that matures in 5 years, with a yield at 5.5%.

That’s definitely better than the low yields (3% to 4.5%) earned by shorter “paper”.

I could get a higher yield for my money if I “extended” to 20 years, but for an extra ½ percent, it’s not worth it.

And, if I don’t get paid more to tie up my money for ten years (the yield is still 5.5%), then I’ll stay with the 5 year bond.

INVERSE YIELD CURVES

Looking at my screens on August 14, Treasury yield curves were definitely inverted, as they have been since the end of January 2000.

6.3%

6.2% X X

6.1%

6.0% X

5.9%

5.8% X

5.7% X

5.6%

5.5%

years 1 2 3 4 5 6 7 8 9 10 20 30

A picture is worth a thousand words! You earn a LOWER yield if you buy a 30-year Treasury bond than if you buy one that matures sooner!

WHY is this happening? Two main reasons…

Scarcity: The government has a budget surplus this year, and is paying off its debt. (I would too!) And wisely, it pays off the debt with the highest interest rates. In this case, that means retiring the (usually) high-yielding 30-year bonds that were issued in the past. This creates a shortage, leading to higher prices, causing lower yields.

Low inflation: we have seen little inflation for the past 10 years (less than 3%) and the Fed has been working to keep the economy from overheating, so inflation can STAY low. Investors don’t expect inflation, and many think rates will go down.

So, what kind of invest strategy might we exercise?

Next time: using barbells!