Bond investors can usually bank on it: The longer the maturity of a bond, the higher the yield.
But right now, two-year Treasury notes yield 9.17 percent, compared with 9.04 percent on 30-year Treasury bonds, resulting in what is called an inverted yield curve. Instead of a steady slope upward of higher rates for longer bond maturities, yields have started to slope in the opposite direction, with the highest rates on short-term bonds. This is a classic distortion that often appears late in a business cycle.The basic decision for investors is whether to lock in current yields on long-term bonds, in the belief that interest rates in general will fall; or take advantage of high short-term rates, on the assumption that they will continue to rise. Bond prices move opposite to interest rates. When rates fall, bond prices rise, and vice versa.
"Normally an inverted yield curve is an early indicator of slower economic growth ahead," said John Lonski, a senior economist at Moody's Investors Service.
The U.S. economy has been growing for six years and many economists say that unless economic activity slows down, the country is in for a bout of inflation. To help slow things down, the Federal Reserve Board has moved to nudge short-term rates upward by tightening the money supply. Those rates have moved further and faster than long-term rates.
"To a large extent, the Fed can exert influence over short-term rates," said Theresa Havell, director of fixed-income investments at Neuberger & Berman. "Long-term rates are much more anticipatory. They're a prediction of where rates will be in the future."
But long-term bond investors are looking beyond higher inflation to a period of slower growth or even when rates will fall, pushing up the price on today's bonds.
"People feel a recession may be near at hand and traditionally rates would decline when there's a recession," said Robert Vitale, a principal and head of the fixed-income department at 1838 Investment Advisors, a Philadelphia money-management firm.
If that happens, then today's rates on 30-year bonds could look attractive. But even more important, if long-term rates fall, long-term bonds in the market now would rise in price, giving holders of those bonds extra return in the form of capital appreciation.
"The yield curve reflects pretty strong expectations by the market that we'll see lower long-term interest rates next year," Lonski said. Long-term bond investors are willing to settle for a slightly lower yield now in return for big capital gains later.
If yields on 30-year bonds fall as low as 7 percent, for example, in the next 12 months, investors who bought today would be sitting on a total return for the year of roughly 30 percent. If they fall to 8.25 percent, they would still have market appreciation plus yield totaling almost 18 percent.
The catch, however, is that with the economy continuing to roar along, no one knows how much higher rates will go before they fall or when they will hit a peak. Although forecasts vary, many credit watchers expect long-term bonds to edge up from about 9 percent now to perhaps 9.25 to 9.5 percent by the middle or end of next year, and to decline from there.
Lonski believes there are other factors at work here than just expectations about inflation and recession. For one thing, the spate of huge takeovers and leveraged buyouts has monopolized a big chunk of available bank financing, helping to push short-term rates upward.
At the same time, leveraged buyouts have made long-term, investment-grade corporate bonds less attractive, since such buyouts usually lower the value of bonds already in the market. That has sharply reduced the issues coming to market, and pushed some corporate-bond investors into the government market. Also, many investors who never regained their nerve after Black Monday are shunning stocks in favor of bonds, so demand for the long-term government bond is especially strong, helping to keep those rates from rising as fast as short-term rates.
Generally, short-term bonds are considered less risky than long-term bonds because any adverse development in interest rates would have to be tolerated for a shorter time. If interest rates rise, the price of long-term bonds can fall substantially, resulting in a loss of principal to investors who can't hold them to maturity.
But short-term bond investors face reinvestment risk. That is, if interest rates decline and investors hold only very short-term investments, they would have no choice but to reinvest at prevailing low rates.
The easiest access to the bond market for most individuals is through mutual funds. Many fund families offer bond funds with a spectrum of maturities, from very short-term money market funds to long-term bond funds and high-yield, or "junk-bond," funds.