Investing Curves

One of the basic principles in bond investing is the relationship between bond prices and changes in the yield curve.

You would be hard pressed to find a money manager who would not agree that interest rates are likely to rise at some point in the future.  But you will find differing opinions on where rates will rise along the yield curve and when it will happen.

For those who need a refresher, the yield curve measures interest rates along the vertical axis and time along the horizontal axis.  What it tells us is the approximate yield a bond for a given maturity is currently earning, and under normal conditions, the longer the maturity the higher the interest rate.  Even in its simplicity, the yield curve and how it responds to external developments offers a good example of how challenging bond investing can be.  As we review the current environment and likely direction of interest rates, it might be helpful to consider how the yield curve can change.

Recall the early part of this decade.  After a tech led stock market sell-off that saw the Nasdaq lose 75% of its value, the Fed lowered short-term rates to stimulate lending, which I say not surprisingly, led to a yield curve that matches today's yield curve as illustrated below.  I say not surprising because both periods followed a financial crisis.

Yield curve graphic provided by Fidelity Investments where you can find historical yield curve information along with other important yield curve concepts.

The image above is a snapshot of the yield curve in June of 2003 (shaded area) and the current yield curve (yellow line).  I remember distinctly back in 2003 a marketing rep for an investment product company suggesting that their inverse long-bond fund would be a good way to protect clients from rising interest rates.  But the long end of the curve barely moved after 2003.

Rates did rise.  Remember The Fed meetings in 2004 through 2006?  It turns out the curve moved a lot during that time but it was all at the short end of the curve as the graphic below illustrates.  The gray area is where the yield curve was in May 2006.  The yellow curve is where the yield curve is today.

Yield curve graphics provided by Fidelity Investments.

Long bonds have been in a bull market since the U.S. escaped the inflation-plagued 70's and early '80's.  As prices climbed (see chart below), interest rates fell.  That is not a trend that will continue indefinitely.

Today we have an example of near-zero rates at the short end of the curve with The Fed Fund rate at 0.2%.  At the other end of the curve, the current yield on a 30 year Treasury bond (long bond) is around 3.7%, so long-bond prices could potentially appreciate much more if interest rates were to continue to fall.  How much more?  Around 15-20% from today's price level, but it is not likely to happen unless we have another financial crisis.  The last time the long-bond prices spiked was December of 2008, when yields reached an ultra low level of 2.5%

Another interesting point of comparison is the interest rate spread between different maturities.  Under normal conditions the interest spread between the Fed Funds Rate and 30 year Treasury Bonds is around 2%.  It is currently around 3.5%.  The spread can narrow one of three ways.  Either the short rate can go up, the long-bond rate can come down, or some combination of both.  The graphic below shows the type of curve which results from changes at the long and short end of the curve.

Yield curve graphic provided by Fidelity Investments.

At present the Fed is telling the market it does not expect to be raising rates anytime soon.  Since 1977 the Fed Funds rate has been as high as 22.36% and as low as the current .20% and 30-year Treasuries as high as 15.2% and as low as 2.53%.

Since 1992, a less volatile interest rate period, the Fed Funds rate has been as high as 7.8% and as low as the current .20% and 30-year Treasuries as high as 8.16% and as low as 2.53%.

For a look at today's yield curve compared to this historical average see the graphic below.

Yield curve graphic provided by Fidelity Investments.

There is reason to be concerned about long-bond prices if rates rise.  A 20+ year bond could see prices fall around 30% if the long end of the yield curve moves up 2%.  Yes, bond holders will receive their full principle upon maturity in 20+ years, but it will purchase less than today if we enter into an inflationary period.

Interest rates are influenced by many economic and political factors outside of this commentary.  It does appear most governments are focused on inflating their economies out of the current over-leveraged environment.  Yes, some austerity measures are underway, but governments are letting bad debt remain and continuing to support promises they most likely will not be able to meet.  When a problem arises it is met with currency printing by central banks.  So far their actions have not unleashed inflation in developed countries and it probably won't until consumers get their finances in order and real economic growth resumes.

The game of governments trying to fix economic problems with additional currency injections can go on for a long time.  We only need to look at Japan over the last 20 years as an example.  At some point this scheme will end and potentially very badly in the form of crippling inflation.

There are generally two different events that create a higher interest rate environment.  The first is strong economic growth.  As the economy heats up the Fed moves into a hawkish mode and raises interest rates to slow the economy.  There is very little evidence the Fed will have any reason to raise rates due to economic growth anytime soon but it is exactly why they raised rates between 2004 and 2006.

Another possibility is buyers of U.S. debt demand higher interest rates.  While this could develop, I believe we would see this event first occur in other large developed countries under more severe financial pressure.

While there is no question we are at a historically low rate at both ends of the yield curve, it is quite possible we could be in this type of environment for a much longer period of time.  It is also possible the short end will move up without a move up at the long end.

So what should investors do?  That is a complicated question and depends on many variables.  It is probably a reasonable approach to invest at the short to middle of the yield curve.  Some bonds, like corporate bonds or international bonds, can add diversification.  It is also a good idea to watch rates closely and be prepared to shift or hedge your strategy in the event the yield curve starts to shift, especially at the long end of the curve.  If long rates rise dramatically, inflation is on the way and it will affect a lot more than your bond portfolio.