Drew O’Neil discusses fixed income market conditions and offers insight for bond investors.
A “normal” yield curve is positively sloped, meaning that yields get progressively higher as maturities increase. This provides investors an incentive to extend out into longer maturities by offering higher yields the further one moves out on the curve. Currently, the shape of most yield curves is not “normal.” The Treasury curve is inverted, meaning that short-term yields are higher than longer-term yield. More importantly to investors, the corporate bond yield curve is also slightly inverted (essentially flat) and the municipal curve is flat out to ~10 years, where it then begins to steepen.
Buying bonds when the yield curve is flat is understandably perplexing to many investors. The gut reaction for many investors is to simply purchase very short maturity bonds. The thinking goes that if you can earn the same yield in a 1-year bond as you can in a 10-year bond, why take on the additional duration risk? There are several reasons why, which I will discuss below. For illustrative purposes, I will assume a perfectly flat yield curve at 5%, meaning all bonds, no matter what the maturity have a yield to maturity of 5%.
The first thing to remember is that yields are quoted on an annualized basis. This means that if you purchase a 10-year bond at a 5% yield, you aren’t earning 5% total, you are earning 5% every year for 10 years. To put it in dollar terms, a $1,000,000 investment into a 1-year bond yielding 5% will earn $50,000. The same investment in a 10-year bond will earn $500,000.
The second is reinvestment risk. Let’s say you purchase the 1-year bond. One year from now your bond has matured and you have to reinvest the cash. If 1-year yields are still 5%, will you be happy with that and reinvest into another 1-year bond? If so, then what about the next year? Will you reinvest in another 1-year bond at 5%? And so on and so on… If you will continually be happy earning 5% annually, you just keep the reinvestment going. That is exactly what purchasing a 10-year bond yielding 5% does for you: it will earn you 5% annually for 10 years. The major difference is that in purchasing the 10-year bond now, you lock in that 5% annual yield for 10 years. If you choose to keep reinvesting 1-year bonds, you have to hope that yields aren’t lower a year from now, or a year after that, and so on. You only locked in your yield for 1 year, so a year from now you have to take what you can get in the market, which may very well be a lower yield.