LOGIN
MAIL
SEARCH
Inverted yield curves and fixed income investing
By Seth Hammer, CPA, Ph.D.
Towson University
A relatively unusual economic condition emerged in the winter of 2005-06 — the inversion of the yield curve for U.S. government securities.
Whereas longer-term Treasury securities typically provide higher returns than those of shorter durations, recently there has been an exact opposite occurrence. At the market’s closing on Feb. 28, 2006, for example, yields for two-year Treasury notes, at 4.68 percent, were higher than those for 10-year Treasury bonds, which yielded 4.55 percent. Financial advisors may need to share with their clients the potential ramifications of such a condition and provide them with alternative plans for fixed income investing.
The greatest cause for concern of an inverted yield curve, based on historical data, is that it may signal the start of an economic recession. The pattern of inverted yield curves emerging before a recession has applied to the recessions of 2001, 1990, 1981, 1980, 1973, 1969 and 1960. Further, historical data indicate there has been a consistent negative relationship between future subsequent economic activity and declines in the spread between short-term and long-term interest rates, with lead times of about four to six quarters.
Nonetheless, despite these patterns, it is far from certain that there will be a recession. One distinction of the current period is that the general flatness of the yield curves results from long-term rates being unusually low, rather than short-term rates being unusually high. Also, there have been instances, in 1995 and 1998, where recessions did not follow inversions of the yield curve.
Practical alternatives and / or supplements to intermediate and long-term U.S. government bonds during this period may include municipal bonds, I-bonds and hedged foreign bonds.
Municipal bonds may present a strong alternative for investors, especially those subject to higher marginal tax rates, who are seeking to still receive a premium for holding securities of a longer duration. While there has been some flattening in the yield curve for municipal bonds, it has not yet become inverted (as of Feb. 28, 2006). For example, on Feb. 28, 2006, the average yields for two-year and 10-year triple-A-rated, tax-exempt insured revenue bonds were 3.36 percent and 3.91 percent, respectively.
Clients who seek the alternative path of investing in municipal bonds, however, should be advised that the process may be more complicated than that associated with U.S. Treasuries because of potential tax issues (e.g., alternative minimum tax addback for private activity bonds) and the relative inefficiency of the municipal bond market. These inefficiencies may arise because the municipal bond market is so vast -- approximately two million domestic bond issues, with a median issue size of only $12 million. These inefficiencies may result in the investor being at risk for high bid / ask spreads, lack of diversification and / or lack of liquidity.
Another alternative or supplement for investors to consider is U.S. I-bond investments, which can provide real fixed returns, as opposed to absolute fixed returns. I-bonds issued between Nov. 1, 2005 and April 30, 2006 provide a fixed rate of return of 1 percent plus a rate based on the Consumer Price Index for Urban Consumers (CPI-U) that is adjusted every six months. The annualized total rate for I-bonds issued between November 2005 and April 2006 is 6.73 percent.
An important benefit of I-bonds is they allow investors to lock in long-term real rates of return while giving them the option to redeem the bonds at any time after one year with either a zero or three-month foregone interest penalty. These bonds may be especially attractive at this time because of the great deal of uncertainty underlying future short-term interest rates. Should, for example, a huge governmental holder of U.S. Treasury bills, such as Japan, suddenly decide to reduce its holdings of these investments, it could increase the probability that the economy would experience a swift and significant increase in short-term interest rates.
More information about I-bonds may be found here.
A third way to adjust a fixed income portfolio to compensate for the uncertainty arising from an inverted yield curve would be to supplement it with hedged foreign bonds. These are bonds from foreign issuers that are denominated in U.S. currency. They vary from unhedged foreign bonds in that their returns do not fluctuate based on changes in foreign currency valuations.
The addition of hedged foreign bonds to a fixed income portfolio may provide opportunities for reducing volatility, by providing increased diversification, typically through a fund. In cases where receiving a premium for duration is a higher priority than diversification, however, investors may benefit by seeking out and investing in bonds of foreign issuers, where there is not an inversion of the yield curve.
Seth Hammer, CPA, Ph.D., is an associate professor of accounting at Towson University and the author of CCH's “Investments and Taxes: A Practical Guide for Financial Advisers” (June 2004, second edition). His articles have appeared in “Tax Advisor,” “The Journal of Retirement Planning” and other journals. He is a member of the MACPA’s Personal Financial Planning Committee.
Footnotes
1. www.bloomberg.com/markets/rates.
2. “Finance and Economics: The Long and the Short of It; Economic Focus,” The Economist, Jan. 7, 2006, Vol. 378 (8459), pg. 72.
3. “The Yield Curve as a Leading Indicator: Frequently Asked Questions,” by Arturo Estrella, New York Federal Reserve Bank, October 2005, www.newyorkfed.org/research/capital_markets/ycfaq.pdf
4. “Finance and Economics ...,” op. cit., p. 73.
5. www.bloomberg.com/markets/rates
6. “Municipal Mindset: Beating the Municipal Bond Market Requires the Skills of a Sleuth. Does Your Manager Have What it Takes?” By D. Scholl and D. Baldt, Financial Planning, April 1, 2005, p.1.
This content has not yet been Rated.
To Rate content, please Login.