When you buy a bond, you will earn a regular interest payout. The amount of interest payout divided by the price is called the yield. In a typical economic environment, you tend to see the yield for a shorter-term duration bond to be lower than the longer-term duration bond of the same quality. However, this is not always the case, and when the reverse is happening, it is called the inverted yield curve. Let’s dive into this topic and learn what it means to us as investors.
What is a normal yield curve?
The yield curve is a graphical representation of the interest rates of bonds over different maturities. The chart below is an example of a normal yield curve:
The diagram shows that the yield of a shorter-term maturity is always lower than the longer-term maturity. This makes sense because investors must price more premiums to hold the bond longer. Less thing is likely to happen in six months compared to 30 years. Chances for the bond to default within 30 years are significantly higher than within six months. The higher yield compensates for the additional risks investors take to hold the bond for extended periods. Remember, when investing in a fixed-income investment, you want stability. Fewer risks mean more stability. In a healthy economic condition, you can expect the yield curve to be in this shape.
What is an inverted yield curve?
The graph below is an example of an inverted yield curve:
What is happening here? The shorter-term maturity yields much higher than the longer-term maturity. This inversion does not make sense because we are supposed to be rewarded for holding the bond longer due to higher risks over the long period.
The simple answer is that there is a potential for higher risk in the short term. When investors think there is a short-term risk in the market, they want to be compensated by demanding a higher yield. This short-term market risk is why there is a yield curve inversion.
What risk?
What short-term risk are we referring to? Recession. Historically, when the US treasury yield curve is inverted, it is a leading indicator for an upcoming economic recession. When there is a recession, investors tend to hoard cash; thus, they will need to sell their bonds and, as a result, lower the price and increase the yield. Bond yield has an inverse relationship to its price. The market is forward-looking, so it starts pricing in an impending recession by demanding a higher premium for a shorter-term duration bond when the recession is more likely to happen. The yield on the longer-term maturity becomes low because the market expects the central bank to lower the interest rate after the recession as the economy struggles afterward. Economic growth tends to shrink during a recession and only grow minimally for many years.
What does an inverted yield curve mean for investors?
The above is the historical chart of the 10-year US treasury yield minus the 2-year US treasury yield. The US treasury yield curve is inverted when the blue line falls below the black line in the middle (or the 0%). The vertical grey areas represent the recessions. You can observe that a recession usually follows whenever the yield curve is inverted. At least historically, this has been an accurate indicator.
As an investor, when you see the inverted yield curve, you can treat it as a warning sign of an impending recession. Is it guaranteed? Of course not, but it has been a reliable indicator so far. You may use this inverted yield curve indicator and other signals, such as the macroeconomy, unemployment, inflation, etc., to understand the economy’s state. If you think the recession will come, you have a headstart to start positioning your portfolio as how you would position it in a recessionary era. You can position yourself better and take advantage of the possible incoming recession.
What should we do as an investor?
If your investment horizon is shorter, the general wisdom is to be more defensive by holding more cash and defensive stocks. As we likely do not know how deep the recession will be, you can enjoy your retirement better with more stability in your portfolio.
If your investment horizon is longer: as a passive investor, you can stick to the dollar cost averaging strategy to keep investing throughout the ups and downs of the market. For a more sophisticated investor, a recession is an excellent opportunity to acquire assets at a relatively discounted price. If you have been building cash before the recession, you can deploy your cash when the recession comes. As Rothschild put it: “The time to buy is when there’s blood in the streets, even if the blood is your own.”
