The Dividend Investing Resource Center

Letting Dividends Do Their Work

Bonds Part I: Why Should I Care About Bond Yield Curves?

George C. Fisher

I can hear the readers moan as they review the title of this week’s commentary: “Not another boring article about bonds, please.” “I don’t understand bonds, I don’t know bonds and I don’t want to know bonds.” In my opinion, bonds are a powerful investment tool and can be instrumental in the long-term accumulation and preservation of personal wealth. Over the next few articles, I will review bonds from an equity investor’s vantage point.

The “yield curve” is an important tool for investors to use as a reference point when evaluating current income investments and when planning a diversified asset strategy. Yield curves can also be used as a leading indicator of adjustments to the general economy. Equity investors are usually betting on a brighter tomorrow that will send their stock picks skyrocketing. Analysis of the yield curve may assist in determining if that is, in fact, a good bet.

For quick review, a bond is an interest-only loan usually between Uncle Sam or corporate America and private investors. For example, to generate the cash flow needs of the US Government in times when tax revenue does not exceed entitlement and operational expenses, the Treasury Department will sell bonds, or loans, to individual and institutional investors. In exchange for investor’s cash, Uncle Sam issues a note that promises to repay a specified dollar amount on a specific day in the future, and to pay usually semi-annual interest for the use of your money. Investors can usually lend the US Government money for as short a time period as 90 days or for as long as 30 years, and the repayment date is called the “maturity date”. Interest payments are usually set for the life of the instrument when issued, and reflects not only the length of time to maturity but the prevailing interest rate market as well. In most cases, investors will demand a higher yield to compensate for the risks associated with longer holding periods until the bond matures. For instance, as of Feb 11, 2005, a 90-day US Treasury note was generating a 2.20 percent annual yield while a 30-year instrument generated 4.70 percent annual yield. The yield difference between short and long maturities is called the “spread”, and is 2.50 percent in the example above (4.70 – 2.20).

The “yield” is the amount of the annual return on an investment, usually calculated by its income rather than capital appreciation. For example, if a bond investment is worth $100 and offers a $4.70 annual income stream, the bond has a yield of 4.70 percent ($4.70 income divided by $100 value).

The “curve” refers to a plotted graph describing the relationship between the yield and the time to maturity. The graph starts with the shortest duration bond and widens out in time. As the time line progresses, the line graph usually slopes upwards from left to right, depicting higher yields for longer maturities.

As economic conditions change, so do the current interest rate environment and the shape of the yield curve. The relationship between the yield of shorter maturities and longer maturities also adjusts to reflect investor’s perception of the future trend of interest rates and the risk premium demanded for holding longer maturities bonds. The yield curve depicts the difference in income yield that is due solely to the length of time until maturity.

Using a “normal” yield curve, the slope will rise over time demonstrating that bonds with longer maturities pay more than shorter maturities. The steeper the slope, the larger the difference, or spread, between short and long rates. The flatter the slope, the smaller the spread. There are extreme times when short maturity yields are actually higher than longer maturity yields, and this graph depicts an “inverted” slope that starts high and declines as maturities extend.

Consensus is that a “normal” spread is about 3.0 percentage points. For example, a 90-day yield of 2.20 percent would equate to a 30-year yield of around 5.2 percent. Slopes depicting spreads of greater than 3 percent are considered “steep” and those depicting spreads of less than 3.0 percent are considered “flat”. When reviewed as a graph, and especially when reviewed over time, yield spreads can provide ample food for thought.

Historically, if the economy is humming along, the yield curve is in a “normal” slope and the spread is around 3.0 percent. Investors perceive the future to include stable rates and low inflation, and are willing to accept a “normal” yield spread.

A sharp upwards steep slope has often preceded an economic upturn. The assumption is that investors are expecting rapid economic expansion will lead to higher rates interest rates and possibly higher inflation down the road. To compensate, investors may demand greater than a 3.0 percent spread, reflecting a steeper slope to the yield curve. For readers seeking more information, review the yield curves of early 1992 as the economy was recovering from the 1990 – 1991 recession.

A flat yield curve indicates there is smaller than a 3.0 percent spread between short and long rates. Flat curves frequently signal a potential slowdown in economic growth that may be accompanied by more stable or declining interest rates and inflation expectations. Late in an economic cycle, federally regulated short rates rise to decelerate economic growth. However, if investors believe economic factors are close to turning sluggish, long bond yields may decline to reflect expectations of slowing future rate hikes and tamer inflation numbers. This will lead to a flatter slope of the yield curve. For readers seeking more information, review the yield curves of late 1989 and early 1990 as the economy was peaking and turning lower before the1990 – 1991 downturn.

An inverted yield curve can be a leading indicator of a recession. While more dramatic and less frequent than a flattening curve, inverted yield curves are loudly screaming bond investors belief interest rates are about to fall sharply, usually caused by the onset of a recession. For readers seeking more information, review the yield curves of early 2000, almost a year before the recession of 2001.

Investors should keep in mind that higher regulated short-term interest rates do not always automatically mean higher long bond yields. As shown above, during times of flattening or inverted yield curves, raising short rates by the feds does not always create equal hikes in long bond yields.

In early 2004, interest rates were rising as the economy improved. As anticipated, long maturity bond yields also rose. However, by mid-year, investors began to believe future rate hikes would be moderate and global uncertainty increased demand for US bonds. This created an environment for long bond yields to decline while short yields were increasing. At the end of the 2004, long bond yields were about where they began the year, even in the face of multiple rate hikes.

This has created a current yield curve that is much flatter than it was a year ago. The curve for Feb 13, 2004 showed a yield spread differential of over 4.00 percentage points, while today the spread is around 2.50 percentage points, reflecting a rise in short rates combined with a decline in long rates.

So why should an investor care about this flattening of the yield curve? It’s simple.

By flattening out, the yield curve is telling us that bond investors are betting the rate of economic growth along with inflation expectations will slow down, relieving pressure for higher rates down the road. However, if these expectations do not hold accurate, long rates could jump substantially as the spread returns to a more “normal” differential and the yield curve steepens to a “normal” slope.

Historically, as long bond yields rise, capital is siphoned off from the equities market to the bond market. Higher rates of return from virtually risk-free US Treasury bonds become more attractive, especially to conservative investors. In addition, higher corporate interest expenses usually squeeze profits for capital intensive businesses, such as financial companies, and those that are highly leveraged. Lower corporate profits and higher bond yields are not the usually ingredients of a new bull market in equities.

Personally, every week I review the US Treasury Yield curve offered by Barron’s publication, as reported by Bloomberg. It graphs the current week, the previous week and last year’s yield curve. I find this presentation to allow a quick routine study of where equity prices may be headed, at least in the mind of bond investors.

Keep an eye on the yield curve over the next few months. It could be a very interesting leading indicator of what lies ahead for stock prices.

George C. Fisher is a 30-year veteran in DSP/DRIP investing. He is author of All About DRIPs and DSPs (McGraw Hill, 2001) and The StreetSmart Guide to Overlooked Stocks (McGraw Hill, 2002). Mr. Fisher is an avid dividend reinvestment advocate and utilizes the strategy with all dividend paying stocks, both at the broker and direct with the companies using their DRIP programs.

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