Your choice regarding cookies: We use cookies when you use this Website. These may be 'session' cookies, meaning they delete themselves when you leave the Website, or 'persistent' cookies which do not delete themselves and help us recognize you when you return so we can provide a tailored service. However, you can block our usage by adjusting your browser settings to refuse cookies.
SUMMARY
- The short end of the curve has high reinvestment risks.
- The long end of the curve takes on more price sensitivity to interest rate moves.
- The sweet spot to invest on the yield curve is in 3 to 10-year maturities, in our view.
The bond market has risen from the ashes like a phoenix the last few years as interest rates have risen from 1% to over 4% on 10-year US Treasury. During this time, many conversations have arisen regarding the yield curve, which describes the yields on government securities from less than a year to 30 years’ maturity (chart right). We believe that the ‘sweet spot’ on the yield curve to invest in currently is between 3 and 10-years given the present economic environment.
Historically, investors have been able to gain valuable insights about the economy from the yield curve based on its shape and steepness. The various shapes of the yield curve can be upward sloping, downward sloping (inverted), or flat. An upward sloping curve is when shorter rates are lower than longer rates, and vice versa for a downward sloping curve, while a flat curve is when short and long rates yield roughly the same. Currently, the yield curve incorporates all three shapes due to the uncertainty around the path of interest rates, as shown in the chart below.
Short End of the Curve: Reinvestment Risks and Limited Upside
The belief at RiverFront is that interest rates will remain higher for longer. Higher rates for longer can trick investors into thinking that they have plenty of time to remain invested in short-term securities like money markets (see Weekly Views from 4/2/24 and 3/5/24 for more on this). As data can change quickly and given the Fed’s bias towards cutting rates, we see little reason for investors to prolong the move out on the yield curve and lock in higher rates of return. Investing in the short end of the curve introduces reinvestment risk, as yields may be substantially lower when it is time to reinvest the proceeds from a Certificate of Deposit (CD) or bond that has matured.
Despite the Fed delaying rate cuts due to a stronger economy, we expect the economy to slow down within the next year, leading eventually to rate cuts. Maturities two years and shorter should benefit from rate cuts with their yields falling and prices rising. However, the upside appreciation will be limited given the short time until maturity, as bonds trade closer to par as maturity approaches. Thus, the shorter the maturity, the lower the benefit of a rate cut. Hence, we see little value in adding additional fixed income exposure at the front end of the yield curve - even when we consider taking credit risk by buying corporate bonds that command a risk premium above Treasuries which only offer interest rate risk.
Intermediate Part of the Curve: The ‘Sweet Spot’
As we move beyond the two-year part of the yield curve, we see additional opportunities. We believe that maturities ranging from 3 to 10 years provide investors with the best opportunities to generate income by locking in higher yields for longer. As an asset manager that manages balanced portfolios, we believe locking in yields north of 4% for 3 to 10 years will help our clients meet their investment objectives and allow them to rely less on more volatile instruments like stocks. For example, in a 50 percent equity and 50 percent fixed income portfolio in 2020, if the investor needed to receive an annual total return of 6 percent, the equity portion of the portfolio had to return 11 percent, when the 10-year Treasury yielded 1 percent. Fast forward to the present day, where 3 to 10-year Treasuries yield approximately 4.6 – 4.8%, the fixed income portion of the balanced portfolio will deliver more than 2 percentage points of the investor’s 6 percent return. Thus, by locking in current yields for longer investors receive a better risk adjusted return. Chart 2 (below) shows how the S&P dividend yield has been steady since the Great Financial Crisis while the yield on the 10-year Treasury has had a dramatic improvement, making bonds more attractive to hold in a balanced portfolio.
Long End of the Curve: Presents Too Much Duration Risk, in Our View
Beyond 10-year maturities, investors take on significantly more price volatility because the long maturities are more sensitive to changes in interest rates. Currently, we do not see a catalyst for yields on the long end of the curve to decline, as inflation is starting to reaccelerate and show its stickiness. We believe that if inflation does continue to trend higher, the Fed will hold rates higher for longer, thus alleviating the incentive for investing at the long end of the curve. Furthermore, investors are not being adequately compensated for purchasing maturities beyond 10 years due to the flat yield curve, in our view. For example, the 30-year Treasury yields roughly 4.70%, while the 10-year Treasury yield is right around 4.60%. Thus, it generally does not behoove investors to tie their money up for an additional 20 years to pick up an incremental 10 basis points per year. While our preference is in in the 3-to-10-year range, it is important to recognize that long-duration treasuries have a unique role to play in balanced portfolios, primarily as a ‘shock absorber’ against recession and potential downside moves in stock markets.
Conclusion:
The fixed income market remains volatile due to the uncertainty surrounding the timing and the magnitude of the Fed’s interest rate cuts. Thus, the front end of the curve is not appealing to us due to the reinvestment risk the investor faces if the Fed goes through with cutting interest rates in 2024, as intimated by the Fed’s most recent median interest projection of 4.625% by the end of the year. Combine that with a long end of the yield curve that is not compensating investors adequately for the added risk and lacks a catalyst for significant price appreciation. We believe that 3-to-10-year is the ‘sweet spot’ of the curve because investors reduce reinvestment risk, they lock in higher yields for longer, without tying money up for years beyond their investment time horizon.
Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.