Bond yields are supposed to increase with the length of time until the bond matures and you get your principal back. (When I talk about bonds I’m really mean any fixed income investment: bonds, bills, notes, CDs, and so on.) A basic, maybe the basic principle of investing is the risk/reward trade-off. You have to take risk to earn a return. The corollary is also true. The more risk you take, you greater should be your expected reward (return).

 

The risk/return trade-off means there should be a positive relationship between the expected return and the maturity of a bond. The longer to maturity, the higher the yield. Why? Because the longer until maturity, the greater the risk. Risks include inflation reducing the value of the bond, rising interest rates, having to sell the bond at a loss prior to maturity, and, except for US Treasuries, default by the issuer.  

 

The yield curve (return vs. maturity) should be an upward sloping line – yields rise as maturity increases. This is the normal state of the bond market. But look what’s happening right now. The Treasury curve is inverted (I’ll explain that in a minute) and the yield on other fixed income securities is almost flat. Something’s wrong with the bond markets.

 

The Treasury market is upside down. For example, the yield on one year Treasuries is 4.94% and the yield on five year Treasuries is 4.54%. You’re losing 40 basis points of return annually for taking 4 years additional risk. (That’s the inverted yield curve.) Now, you might be willing to take that bet if you thought inflation or interest rates would going to move significantly lower over the next five years but do you really that’s going to happen?   I thought not. One year CDs yield 5.05%, 10 year CDs yield 5.75%. That’s almost a flat curve (no pun intended). Do 70 basis points (.7%) really compensate you for 10 year’s illiquidity and inflation/interest rate risk? What’s the penalty for early withdraw on you CD?

 

Inverted yield curves don’t last for long and are usually an indicator of a peaking/declining economy. Mutual fund investors should be wary. It’s a good time to stay short-term in your bond portfolio and a good time to be cautious about the stock market (especially with the Dow over 13,000). Liquidity is a smart response to an inverted yield curve.