INVESTING
Understanding the Ups and Downs of the Yield Curve
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The Long and Short (and Medium) of Treasuries
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hen a bond expert like Craig Henderson looks at the bond market, one of the things that interests him is the yield curve. It should interest us novices, too, because it tells us where we can get the most bang for our buck with our income investments.
Income investments include everything from passbook savings accounts to 30-year bonds. But the yardstick for the income market is Treasury securities, which are offered in denominations from 90 days to 30 years, making comparisons easy. And that's what the yield curve is: a comparison of rates at the short end of the curve with those at the long end, and everything in between.
Once you've looked at the yield curve for Treasuries, you can build on that, comparing them with other security investments. Henderson, a municipal-bond manager in Chicago, compares them with municipal bonds. Or you can compare them with junk bonds or bonds in emerging markets.
First, you must digest the basics. Short-term security investments are far less risky than long-term security investments. Let's take bank certificates of deposit as an example. If you're willing to lock up your money for five years, you'll get a higher interest rate than if you lock it up for just three months.
That's because the longer the maturity or term of the CD, the more interest-rate risk you face. With a CD, though, the federal government insures the principal and interest on your investments for up to $100,000. When you buy a bond, you might lose principal if interest rates go up and you want to sell.
That's why you need to know whether you'll be paid enough in terms of higher yield for taking on the additional risk of a longer term bond. The yield curve helps you decide.
As of early 1998, the answer was no. That's because long-term bonds paid only a tiny bit more than intermediate-term bonds and only a hair more than short-term bonds. So the pros are keeping their money at the short end of the curve.
Steve Norwitz, of T. Rowe Price Associates, the Baltimore-based mutual fund company, stated that in early 1998, the yield between T. Rowe's "intermediate" Treasury funds of one year and its long Treasury of 20 years was only 17 basis points. Seventeen basis points is less than one quarter of a percentage point; not nearly enough of a difference to justify the long-term bond. That's what experts call a "flat" yield curve.
What the flat yield curve tells us is that the pros think interest rates are still going to drop. If interest rates drop, your bond appreciates. "So the only reason you would go to the long end of the curve now is if you think rates are heading down," Norwitz said. That's a big gamble that novice investors shouldn't take.
Henderson, the Chicago fund manager, trades municipal bonds, or "munis." These are issued by state governments or municipalities and are typically referred to as "tax-free" bonds because they're free of federal tax and also free of state and local taxes if you buy one in your own state. So the rates Henderson looks at are those in the muni market. He sees three basic patterns to the yield curve. Here they are:
1. Upward Slope:
A typical yield curve slopes upward, with the short end paying less than the intermediates and the intermediates less than the long-term bonds. With a gentle slope in the muni market, you might see the short end at 5 percent, the 10-year at 6 percent and the 30-year at 6.75 percent. In that scenario, "I'll go out five to seven years," Henderson says. "I don't get paid enough on the short end and I don't want the risk on the long end."
If the curve slopes up very steeply, say 2.5 percent on the short end and 7 percent on intermediates, Henderson might use what pros call a barbell strategy, concentrating his money in two-year bonds and 10-year bonds. If it slopes upward and then flattens out, he may use what is called a ladder strategy, which means he puts some money on each step of the ladder, perhaps buying three-year bonds, four-year bonds, five-year and so forth.
2. Flat:
A flat yield curve offers pretty much the same yields at each level. For instance, perhaps one-year and 10-year munis each pay 5.5 percent, while the 30-year pays 5.6 percent. With a flat curve, Henderson looks at where he gets the highest yield for the lowest risk. It's bound to be close to the short end.
3. Inverted:
An inverted curve, where the short end pays more than the long end, is rare. For example, munis might pay 7 percent on the short end, 5 percent in the middle and 5.75 percent at 30 years. The United States had an inverted yield curve in 1982. Here the strategy is to buy long. "This is really tough," Henderson says, "because it goes against all your instincts. But what an inverted yield curve is saying is that short rates are going down (in price)."
The yield curve was inverted in 1982 with short rates at 20 percent, long rates at 15 percent and intermediate at 14.75 percent. Henderson advised a client to put $1 million in zero coupon bonds with a 10-year maturity. The million turned into $2.5 million in three years. Can a novice do what Henderson does? Probably not.
"The muni market is one of the most inefficient markets out there," he says. "I look at the yield curve every day of my life, 10 times a day." But even we novices can learn something about where to put our income investments by understanding the yield curve. 
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