The Inverted Yield Curve Isn't A Good Bet For Bond Investors

When investors lend for a longer period of time, long-term bonds usually offer a higher yield than short-term ones. However, when the yield curve inverts, as it has now, short-term bonds offer the highest yields. If this happens, you will be tempted to move money to a short-term bond, or even cash, in order to grab an additional yield. Now that cash yields nearly 5%, you might be wondering why it would be worth investing in long-term bonds that are yielding 3.5%?  

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In my opinion, the yield is only one of two components of total return for bond investors, especially those who have invested in bond funds, with the other being changes in bond prices. It is a fact that investors experienced last year when interest rates surged, driving bond prices down, when the total return on bond investments is lower than the yield. Bond prices and interest rates move in opposite directions, so bond prices and interest rates move in opposite directions as well. It should be noted that rising bond prices tend to add to yield which is consistent with the fact that bond funds' yields and returns often differ from each other.

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Therefore, since yield curves have inverted historically, it is possible to look back on historical yields and total returns to determine if investors would be better off investing in short-term bonds or longer-term bonds during previous yield curve inversions. Among the many factors that influence bond prices is the fact that there are multiple variables that influence them, making it very hard to separate them out. US Treasuries are the only exception, with their prices being driven by interest rate changes.

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My next step was to assess the performance of Treasury securities during previous inversions dating back to 1953. In this case, I compared the monthly yields for one-month Treasury bills, which I consider to be a good proxy for cash, with the yields on five-year Treasury securities. I compared their one-, three-, and five-year total returns when T-bills had a yield that exceeded the yield on five-year Treasury bonds.

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In the past seven decades, I have counted 66 monthly inversions. T-bills were winning about 60% of the time over the next one-year period. However, over three and five years, T-bills were winning only 25%. Over longer periods, investors were often better off investing in five-year Treasuries than one-year Treasuries, despite their lower starting yields.    

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Changing interest rates have shown to have a significant impact on the total return achieved in the long run. It appears that the median yield advantage for T-bills was 1.4 percentage points over one year periods and the median yield advantage for three and five years were 2.4 and 1.3 percentage points, which are all multiples of the 0.4 percentage point average yield advantage for T-bills during inversions.

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Over the last seven decades, two vastly different interest-rate regimes have taken hold. Those who benefited the most from changes in interest rates were primarily determined by the broader interest-rate environment. Interest rates had risen from near zero from the 1950's to the early 1980's, climbing all the way to the high teens. Interest rates returned to near zero over the next four decades before they began to rise again last year after three decades of trending downwards.   

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As a result, yield bets were impacted differently during each period of time. During the first year, T-bills tended to win a lot more often than the three- and five-year Treasury Bonds, but only about half of the time. The reason for this is because the higher initial yields of T-bills were not always enough to sustain their edge when the yield curve turned and five-year Treasury Securities regained their yield advantage. However, since the 1980s, declining interest rates have a big advantage over five-year Treasuries. During the first year, they were successful two-thirds of the time and every time during the second, third, and fifth years.

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When the Federal Reserve dropped short-term interest rates to near zero during the 2008 financial crisis and the dot-com bust in 2000, the tailwind of declining interest rates for five-year Treasury bonds was even more pronounced, providing long-term bond investors with a windfall. After experiencing that experience, one would be justified in wondering whether it is more advantageous to purchase long-term bonds during an inversion. The Fed can be counted on to lower rates aggressively to combat recessions in the years after an inversion, as they have done since at least the 1980s, so longer-term bonds should continue to win even though their starting yields are lower after the inversion.

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My analysis was similar to that of five-year and 20-year Treasuries. Inversions of this time were recorded for 169 months. Despite the higher number of monthly inversions, the results were similar, although more noticeable, as longer bonds tend to be more sensitive to interest rates than shorter bonds. Comparatively to the median starting yield, the median difference in total return was even larger. As a result of this greater interest rate sensitivity during the 1950s and early 1980s, 20-year Treasuries were negatively impacted more so than they had been during the intervening period after the inversion of 1987, but they also won easily since then during the five-year periods after the inversion.

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The key takeaway I got from this is that when we reach for yield during inversions, most bond investors are missing the bigger driver of total return, namely interest rates. In the event of an inversion, it is impossible to predict exactly in which direction the interest rate will move, which means we are also unable to predict whether shortening maturity during such a situation will be profitable, never mind the possibility of losing money. As far as inversions are concerned, investors may be able to predict them with some level of certainty only if they can bet on them with Treasuries. But it's going to be much harder with corporate bonds and mortgage-backed bonds.  

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Choosing a position on the yield curve that corresponds to one's desired level of risk and return is probably the best way for investors to proceed. It may not beat the luck of inversions, but it offers a higher probability that what one signs up for actually happens.