Looking at the yield curve
July 2008
You may have heard the term yield curve from various sources, including the many U.S. Federal Reserve and interest rates discussions that are taking place as a result of the ongoing unpredictability we're seeing in the market today. We've summarized the basics and explained the importance of this evaluation tool to you and the experts. These insights may be helpful as you keep up-to-date on the marketplace, while staying focused on your long-term financial planning.
Interest rates on a graph
At its most basic, a yield curve is a simple graph that depicts the interest rates of bonds that are of equal quality, but have different maturity dates. The resulting curve of the graph shows whether short-term interest rates are higher or lower than long-term rates in today's market.
The yield curve above is representative of a typical investment environment, where short-term interest rates are lower than long-term rates. This causes the yield curve to slope upward in the configuration often referred to as a "normal" yield curve.
Because the yield curve shows the relationship between short- and long-term interest rates, some investors examine the yield curve for what it may indicate about the current investment landscape, including, among other things:
-
present investment opportunities
-
investor sentiment in the bond market
-
the broad economy in general
Why is it "normal" for short-term interest rates to be lower?
Investors willing to "tie up" money for longer periods usually demand higher yields for doing so. To understand why, consider some of the additional risks assumed by investors of longer-term maturities, which include:
-
potentially lower marketability of their securities
-
increased potential that fluctuations in interest rates will negatively affect principal
-
the time value of money
Flat and inverted yield curves
When the difference between short- and long-term interest rates narrows, the yield curve begins to "flatten." A flat or less-sloped curve is often seen during the transition from a normal yield curve to an inverted, downward slope, like the one shown below.
An inverted yield curve is one in which bonds with shorter maturities have higher yields than bonds of longer terms. This type of environment often occurs when interest rates are temporarily high and investors expect them to decline. Economically speaking, an inverted yield curve is a noteworthy event because generally, but not always, a significant slowdown or recession follows a yield curve inversion.
Yield curve inversions generally occur late in Fed "tightening cycles" — when the Fed raises interest rates in an effort to constrict spending in an economy that is thought to be growing too quickly and where inflation may be rising too fast. Generally, as the Fed's tightening restricts credit, the economy gradually slows. Markets often react to the slowing economy by anticipating that this will cause the Fed to reverse course and start lowering rates. This is when a yield inversion typically occurs because the Fed continues to increase rates faster than bond yields rise, or the Fed is on hold while bond yields decline.
An inverted yield curve is identifiable by the inverse relationship between yield and maturity.
What an inverted yield curve indicates
Inverted yield curves seem to defy common sense — why would anyone be paid more to hold bonds or other securities for a shorter length of time? The answer is often that long-term investors will settle for lower yields on longer-maturity bonds now if they think that interest rates are going even lower in the future.
Short-term interest rates surpassing long-term rates can be indicative of negative economic sentiment. An inverted yield curve may suggest that the long-term outlook is poor and that investors believe the yields offered by long-term fixed income will continue to fall. (Source: www.newyorkfed.org.)
Inverted yield curves also frequently spark debate about the direction of the economy. Yield curve inversions are generally thought to occur late in a cycle of interest rate increases made by the Fed, and inversions often precede economic slowdowns.
Delaware Investments and yield curve analysis
Monitoring the yield curve is a continual part of the day-to-day responsibilities that come with being a professional fixed income analyst.
Zoë Bradley, vice president and fixed income product specialist, explains that at Delaware Investments, our style typically does not rely on anticipating interest rate changes. In-depth fundamental research is the cornerstone of our fixed income investment process. However, analysts' opinions about the economy, state of the business cycle, and Fed policy are incorporated into the management of funds in terms of yield curve positioning, sector selections, and security structures.
"At Delaware Investments, we manage several mutual funds that are diversified across multiple bond market sectors as well as funds designed for fixed income investors with different time horizons," Bradley says. "A professional advisor can help investors choose an appropriate asset mix that may be right in any environment, given an individual's specific goals, time horizon, and appetite for risk."
Potential effects of an inverted yield curve on investors
Keeping in mind that investors should strive to maintain a long-term perspective whenever possible, let's look at some of the more immediate ways an inverted yield curve may affect the current investment environment.
Fixed-income securities. As you might assume, a yield curve inversion generally has the most direct effect on fixed income investors. Similarly, changing interest rates have a greater impact on bonds with long maturities than on those with short maturities. As interest rates rise, the price of long-term bonds drops more quickly than the price of short-term bonds.
Historically, the bond market has had its best performance between the time that the yield curve inverts and when the Fed begins to lower rates. This is generally caused by anticipation in the bond market that a slowing economy will cause the Fed to go on hold and eventually cut rates. In a recent example that may ultimately be viewed as reflecting this typical behavior, the market experienced an inverted yield curve during the second half of 2006 and the first third of 2007, and the Fed cut rates several times from September 2007 through early 2008.
In normal circumstances, long-term investments generally receive higher returns than their short-term counterparts, although there are no guarantees and investments are not insured. For at least a brief period of time, an inverted curve may eliminate the "risk premium" for long-term investments, allowing investors to get better yields with short-term investments.
Equity securities. When the yield curve becomes inverted, many companies see changes in their profit margins. This is most often the case with companies such as banks and other financial institutions that may borrow cash at short-term rates and lend at long-term rates.
In the past when an inversion led to a recession, investors often turned to stocks that are considered "defensive" — for example, healthcare, food, oil, and tobacco industries.
The demand for these products is generally less cyclical and much more consistent. As such, these types of businesses are often considered to be less affected by downturns in the economy. Noncyclical companies also tend to be less dependent on interest rates and may fare better than other companies when the yield curve inverts or a recession occurs.
Historically, yield curve inversions have predicted economic slowdowns and Fed easing cycles. In the case of bonds, yields typically begin to decline near the end of a Fed tightening cycle or after the Fed goes on hold, although performance after the Fed begins to start cutting rates is often mixed. The full effects of yield curve changes on bonds and equity investments in 2008 are yet to be seen.
Keep in mind that, although it is interesting and tempting as an individual investor to focus on economic swings and what the short-term future may bring, looking back on the economy as it has evolved over past decades teaches us that investors are more likely to benefit from a portfolio based on long-term — not short-term — market movements. A financial advisor can assist you in constructing such a portfolio.
All Delaware Funds are offered by prospectus only. The prospectus contains more complete information on advisory fees, distribution charges, and other expenses and should be read carefully before investing or sending money. A printed copy of any Delaware Investments fund prospectus may be obtained upon request by calling Delaware Investments at 800 523-1918 or downloaded at www.delawareinvestments.com.
High-yielding, non-investment grade bonds (junk bonds) involve higher risk than investment grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.
A rise/fall in interest rates can have a significant impact on bond prices and the net asset value of the fund. Funds that invest in bonds, particularly those with longer maturities, can lose value as interest rates rise and an investor can lose principal.
Diversification does not ensure a profit or guarantee against a loss.
Information in this article is not and should not be construed to be financial advice.
Delaware Investments is the marketing name for Delaware Management Holdings, Inc. and its affiliates, which include Delaware Distributors L.P., a registered broker dealer and primary distributor of the Delaware Investments® Family of Mutual Funds. Lincoln Financial Group is the marketing name for Lincoln National Corporation and its affiliates.
|
