The Federal Reserve (Fed) decided to push up short-term interest rates at its March meeting, the second rate hike in the past three months. Treasury yields across maturities rose leading up to the meeting, with short-term rates rising the most as markets took into account the Fed’s expected pace of three to four rate hikes in 2017. This has caused the yield curve to flatten, but with global reflationary trends and the broad shift from monetary to fiscal policy, the yield curve may again steepen. Is a steepening yield curve good or bad for bond investors? To answer that question, let’s review some fixed income basics today.
What is the yield curve and why does it matter?
The yield curve illustrates the relationship between yields, or interest rates, and the length of time until a security matures. Normally, the yield curve is upward sloping and shows that a security with a longer maturity pays a higher yield than a similar security with a shorter maturity. For example, on March 17 the yield on the 10-year Treasury note was 2.50%, while the yield on the 30-year Treasury bond was 3.11% (source: Bloomberg). You would see a similar relationship if you were to borrow money from a bank. Chances are, you’d pay a higher interest rate for a longer term loan than for a shorter term loan. A 15-year mortgage, generally, would have a lower interest rate than a 30-year mortgage.
Why not just buy long term bonds to maximize income?
Longer maturity securities tend to pay more yield to compensate for the extra risks involved in lending money for longer periods of time. Longer time frames increase the chances that the borrower may not pay back the loan, or that interest rates could shift. This increase in risk is the tradeoff for getting a potentially higher yield.
What about those risks?
Two of the biggest sources of risk when investing in fixed income securities are interest rate risk and credit risk. Interest rate risk is the risk of an increase in interest rates while you’re holding a security. Because interest rates and bond prices move in opposite directions; if interest rates rise, the value of a fixed income security falls.
Credit risk is the risk that an issuer’s financial situation deteriorates and it is not able to make planned coupon or principal payments. Many issuers are rated by national credit rating agencies. Issuers with higher credit ratings generally pay less interest than issuers with lower credit ratings as they have a lower risk of defaulting on their loans.
When I look at San Francisco’s Bay Bridge, I see the yield curve…
The slope of the cables of San Francisco’s Bay Bridge looks a lot like a normal yield curve, as shown in this video. If you invest on the short end, you get paid a lower level of yield. As you move to the longer end of the curve, you get paid more and more yield for investing in longer maturity securities. For securities of similar credit quality, you typically get paid the highest interest rate for purchasing the longest maturity security.
When considering fixed income investing, the yield curve—like the Bay Bridge—helps illustrate this typical core fixed income concept: higher risk, higher reward. Given similar credit profiles, a shorter maturity security will generally pay you a lower interest rate, but you’ll be taking on less risk than if you invested in a longer dated bond that should pay a higher yield.
So, do I want a flattening or steepening yield curve?
It depends on where you are invested. In general terms, if you own short maturity securities, you could benefit when the yield curve steepens as short-term rates are likely falling, or at least rising less than longer-term yields. Conversely, if you hold long maturity securities, you could benefit if the curve flattens, bringing down longer-term yields and boosting long bond prices.
Regardless of the shape of the yield curve, there are reasons to consider investing in bonds. For most investors, having a long-term approach based on clear investment goals is better than worrying too much about the shifts in the curve. If you are seeking stability and pursuing income, consider iShares Core Total USD Bond Market ETF (IUSB) to potentially help strengthen the core of your portfolio.
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