Where should fixed income investors look to participate on the yield curve? The answer depends on each investor’s specific financial needs and circumstances; however, let’s address the question based on the broad-based opportunities available on the yield curve.
There are two observable differences between today’s Treasury yield curve and 10 years ago. Currently, rates are significantly higher across all maturities. Prior to the last two years, interest rates were considerably lower for more than 15 years. The 10-year Treasury rate has averaged 4.30% over the past two years, compared to 2.41% during the 15 years preceding that period. Investors can earn interest in their Treasury investments at 178% higher levels than during those 15 years.
The other difference is that today’s Treasury yield curve is relatively flat and still inverted at the very short end. This can be an indicator of a recession, although many market pundits question this, as the Treasury yield curve has remained inverted for an unusually long period without a recession. The employment numbers have remained strong, providing consumers with the means to spend money and keep the economy moving forward. The dynamic has created much debate over the Federal Reserve’s monetary policy, with many experts advocating for rate cuts to help sustain the economy. In contrast, others caution against inflation remaining higher than preferred, as well as the concern that a Fed rate cut could reignite higher pricing (inflation).
Another important observation is that the curves for different products have distinct shapes, offering various opportunities across product types. The corporate and municipal yield curves reflect considerably higher tax-equivalent yields versus the Treasury curve at most points on the curve. They also reflect much steeper shapes, in particular on the municipal curve. A steep curve indicates that investors are rewarded with a higher yield for extending maturities. Extending out means that investors take on more market and interest rate risk. The longer money is in the market, the longer the exposure to market dynamics. The trade-off to analyze is the income reward versus the market risk. The steeper the curve, the greater the reward relative to the risk.
A common misnomer is that staying short is “conservative,” when depending on the circumstance, it may be viewed as conservative or aggressive. Investing in short-term maturities is as much a call on interest rates as investing in any other maturity. Consider the bigger picture. If an investor believes interest rates are going to fall, perhaps triggered by Fed cuts, investing short can be viewed as “aggressive.” This investment is being made, assuming rates are going down and thus forcing the reinvestment of funds at a time when rates are likely to be lower.
Fixed income allocations are often placed as a ballast to growth asset allocation. In other words, fixed income is primarily dedicated to helping preserve capital, rather than grow it. What is unique about today’s market is that fixed income not only helps safeguard capital but can also contribute to income due to elevated rates. Economic cycles can be extended. Two years ago, rates rose from a prolonged period of low interest rates. Locking in for longer is a calculated and potentially lucrative strategy. Rather than attempting to prognosticate where interest rates are headed, recognize what is known. Rates are currently elevated, presenting an opportunity to secure high levels of income for an extended period.
Your Raymond James financial advisor can analyze your particular situation. In general, high-quality, investment-grade corporate bonds with maturities of 5 to 20 years capitalize on the steep part of their yield curve. Municipal bonds, especially for high tax bracket investors, exhibit greater value longer on the municipal curve, which is the steepest of all the curves. Tax-equivalent yields in high-rated issues are comparable to historical growth-like returns. I encourage you to read this week’s MBIW, which dives deeper into the municipal opportunity. An in-depth look at today’s yield curves reveals the rationale and reasons why many investors are seeking to lock in for longer.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
Investment products are: not deposits, not FDIC/NCUA insured, not insured by any government agency, not bank guaranteed, subject to risk and may lose value.
To learn more about the risks and rewards of investing in fixed income, access the Financial Industry Regulatory Authority’s website at finra.org/investors/learn-to-invest/types-investments/bonds and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) at emma.msrb.org.
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