Curving the Future

As the last days of summer play out, it’s time to look at some curves. No, not those kinds of curves. The yield curve associated with the bond market.
The longer it takes a bond to pay you back, the higher its yield. The yield is the interest rate that a bond pays you if you hold it until it pays off. This only makes sense: longer bonds expose you to more risk. The borrower has a greater chance of going bankrupt. Inflation rates have a greater chance of rising and eroding your wealth. Periodic interest payments have to be reinvested, and a longer bond has more of these.

So the longer the bond, the greater its risk. And more risky bonds offer investors higher interest rates. This phenomenon is called the “yield curve,” and its shape tells us something about how bond investors view the future.

Right now the curve is pretty steep. Short-term rates offer almost no yield at all. Out two years, they’re at 1%. Out five years, they’re at 2.5%. And at 10 years, they’re close to 3.5%. They’re telling us that the market expects rates to go up about 1% per year for the next several years, no matter what the all economists and politicians are saying.

Bond market investors vote with their wallets, and buy and sell billions of dollars in bonds every day. If they expect interest rates to rise, it’s a good idea to listen to what they are saying.

Douglas R. Tengdin, CFA
Chief Investment Officer
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