Bond Investors Shouldn’t Gamble on the Inverted Yield Curve

Long-term bonds usually pay a higher yield than shorter-term ones to encourage investors to lend for longer. But sometimes the so-called yield curve inverts, as it has now, and short-term bonds offer the highest yield. When that happens, it’s tempting to move money to short-term bonds, or even cash, to grab that extra yield. Now that the yield on cash is nearly 5%, why bother with long-term bonds offering 3.5%?

The answer is that for most bond investors, particularly those who own bond funds, yield is only one component of total return, the other being changes in bond prices. When bond prices decline, total return will be lower than the yield, a reality investors encountered last year when interest rates surged, sending bond prices lower (interest rates and bond prices move in opposite directions). Inversely, rising bond prices add to yield, all of which is confirmed by the fact that bond funds’ yield and total return almost always differ.

Knowing that, it’s possible to look back at historical yields and total returns to determine whether investors were better off with short-term or longer-term bonds during previous yield-curve inversions. The tricky part is that, for most bonds, multiple variables influence prices, and it’s hard to disentangle them. One notable exception is US Treasuries, whose prices are driven by changes in interest rates.

So I looked at how Treasuries performed during previous inversions going to back to 1953. I compared monthly yields for one-month Treasury bills, which are a good proxy for cash, with those of five-year Treasuries. In months when the yield on T-bills exceeded that of five-year Treasuries, I compared their subsequent one-, three- and five-year total returns to see which performed best.

I counted 66 monthly inversions during the past seven decades. T-bills won about 60% of the time over subsequent one-year periods. But over three and five years, T-bills won only a quarter of the time. So despite a lower starting yield, investors were more often better off with five-year Treasuries over longer periods.