This report was prepared by my firm LPL Financial. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not ensure against market risk.
One of the areas of opportunity that I’ve been finding for my clients have been in the bond market. Although, there are plenty of areas in the equity market, certain bonds offer attractive yields with the potential for appreciation as well. Most of this is due the relationship between treasury yields and their respective bond counterparts. This report by my firm illustrates more on this yield curve relationship and why this might be an opportunity for investors.
What is The Yield Curve?
The yield curve, a graphical representation of yields across the maturity spectrum of the bond market, has long received attention as a relatively good leading indicator. A flat or inverted yield curve has often predicted an economic slowdown or recession while a steep yield curve foreshadows economic growth.
For bond investors, a steep yield curve provides benefits not often discussed but are used by the professionals. A steep yield curve provides:
- Substantially higher compensation, in the form of higher yield, for each year an investor extends maturity.
- Better protection against rising interest rates.
The current slope of the yield curve is at historically steep level. On a simplistic note, the steep yield curve provides added compensation for every year an investor extends maturity. The steeper the yield curve, the greater the benefit to extend maturity. For example, in the Treasury market, investors can pick up an extra 0.40% in yield merely by buying the 2-year note rather than a 1-year Treasury bill. Similarly, an investor can pick up an extra 0.35% in yield by extending from 2-year to 3-year maturity bonds.
While this yield pick up might not seem like much, it can provide some impressive defensive qualities for bond investors. For example, as of April 20 the current 3-year maturity Treasury note referenced above yields 1.27%. Over a 1-year time horizon, interest rates would have to rise by more than 0.99% before an investor suffered a loss on a total return basis. While the price of the bond would decline to $989.34 (per $1000 face value) from today’s $1002.81 (a $13.47 loss), the bond would have paid $13.75 in interest income. While naysayers might focus on price alone, ignoring interest income, the main source of a bonds return over time, would not be a fair analysis.
A 0.99% yield increase is substantial and would likely require the assistance of one or more rate hikes by the Federal Reserve or the market moving to price in the start of a rate hike campaign. We’d view this as a low probability over a one-year time horizon.
The analysis above exemplifies the defensive benefit a steep yield curve provides. Among bond professionals this concept is known as “roll down”, that is, when the yield curve is steep a bond will “roll down” the yield curve into a lower yielding, shorter maturity and this supports bond pricing.
Note that the analysis above does not include interest on interest from reinvestment. Since most bonds pay semi-annually, the first interest payment could be reinvested generating additional income. Depending on the income reinvested, this could create an additional buffer before suffering a loss. Conversely, the analysis above does not take into account transaction costs which could have a significant impact on smaller investments.
The cost of waiting
Simply extending maturity is perhaps of greatest interest to investors invested in cash or other very short-term instruments. We can compare the 3-year Treasury note cited earlier versus an investor who simply bought and held a 1-year t-bill, yielding 0.51% as of April 20. In this case the buffer is less, but the 3-year Treasury note investor could withstand a 0.74% rise in interest rates and still break even with an investor who bought and held a 1-year t-bill.
Should interest rates not increase by that amount, however, the investor of the 1-year t-bill would require an even greater yield increase going forward (over the remain two years) to make up for the lost yield relative to an investor who purchased a 3-year note. This puts the 1-year investor at a greater and greater disadvantage should yields not increase fast enough let alone decline. Guessing correctly on interest rates is difficult at best and why individual bond investors choose “laddered” strategies or diversified managed bond portfolios, which can also help benefit from steep yield curves.
What’s the Risk?
The risk to “riding the yield curve” is that interest rates rise faster than what is implied in the shape of the yield curve. But this is one strategy that can be implemented in a diversified portfolio and, as shown, yield curve slope is historically steep.
The ability to ride the yield curve is another reason why we continue to focus on intermediate maturity bonds and prefer to take exposure via sector allocation rather than make a bet on the direction of interest rates. We used the Treasury market as an example but yield curves are even steeper in non-Treasury sectors. Bond portfolio managers take advantage of roll down and wide yield differentials between various maturity segments whether it be Corporate, Agency, or Treasury Bonds. We presented just once example via the 3-year Treasury but there are a multitude of segments along the yield curve (two versus three years, four-year versus five, etc) that may present opportunity.
This weeks Carnivals:
- The Carnival of Personal Finance was hosted at Mighty Bargain Hunter.
- Festival of Frugality – I May Be In Incredible Pain But At Least I’m Living Frugal Edition was hosted at My Life ROI.
- Money Hacks Blog Carnival – Earth Day Edition was hosted at The Personal Finance Playbook.
- Carnival of Pecuniary Delights #4: Living Green & Saving Green Edition
IMPORTANT DISCLOSURES
- The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
- Neither LPL Financial nor any of its affiliates make a market in the investment being discussed nor does LPL Financial or its affiliates or its officers have a financial interest in any securities of the issuer whose investment is being recommended neither LPL Financial nor its affiliates have managed or co-managed a public offering of any securities of the issuer in the past 12 months.
- Government bonds and Treasury Bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
- The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
- High Yield/Junk Bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors.
- GNMA’s are guaranteed by the U.S. government as to the timely principal and interest, however this guarantee does not apply to the yield, nor does it protect against loss of principal if the bonds are sold prior to the payment of all underlying mortgages.
- Municipal Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and state and local taxes may apply.
photo by Sean Molin | Photographer
