Staying Ahead of the Curve

Staying Ahead of the Curve

Want to know where bonds are headed? Consult the yield curve

Should you buy a three-month T-bill, a 30-year bond, or something in between? A look at the yield curve, which can be found daily in the Wall Street Journal or Investor’s Business Daily, may provide the answer.

A yield curve is simply a line that plots the interest rate paid by similar bonds with different maturities. The X-axis plots the length of time until the bonds mature. The Y-axis plots the yield of each bond. The average spread between the shortest-term and longest-term Treasuries is usually about two percentage points.

Reading the yield curve can be especially useful for long-term investing. If you have a shorter time frame – say, you’ll need to cash in your bond in three years for a child’s tuition – you should probably buy a bond that matures within that time period. Keep in mind, also, that interest rates and bond prices move in opposite directions: Higher rates mean lower bond prices. Rising interest rates can play havoc on the bond market. This was the case in 1994, when even the highest-quality bond portfolio lost value as interest rates climbed. When rates start heading down, on the other hand, it’s usually a good time to buy long-term bonds as a way to lock in current high yields.

A common misconception is that if a bond’s yield is going up, the investment is worth more. It’s just the opposite; when a bond’s yield rises, its price has fallen because the increase in yield comes at the expense of the bond’s market value. Conversely, if a bond’s yield falls, its market value rises. Another risk: rising inflation, which can cut the worth of bond’s coupon payments and its eventual redemption value.

The yield curve usually slopes upward. That’s because longer-term investments carry more of the aforementioned risks and must pay higher interest rates to compensate. When short and long-term interest rates are roughly the same, the curve is flat. A thin spread means the market sees little difference between the short-term and long-term risks of inflation. So buying longer-term bonds gives you only a slight premium.

Grand Central Railway Station in New York. Photo by Elena

When short-term yields exceed long-term yields, the curve turns downward or inverts. An inverted curve usually means that a recession is coming. The last time the curve inverted was 1989, signaling the slowdown that led to the 1990-91 recession. An inverted curve has predicted all eight recessions since 1950.

Some analysts say that inverted curves also signal a buying opportunity for long-term bonds. In other words, when the economy softens and interest rates come down, you want to be in long-term bonds because eventually the curve will normalize and the value of long-term bonds will rise.

Reading the Yield Curve

Yield curves show how interest rates and time to maturity relate in otherwise similar bonds. A normal, or positive, yield curve moves upward, showing that interest rates rise as maturities increase. When the curve invests, or bends downward, short-term rates are higher than long term rates, a sign of a recession to come.