Column: outguessing the yield curve
Are you a good guesser? If so, you might be tempted to apply your skills to the investment world. For example, if you’re interested in investing in bonds, you might want to try outguessing the “yield curve.” But be careful – making the wrong guess could be expensive.
You may have seen the daily yield curve published in the Wall Street Journal or another newspaper, but what is it exactly? Essentially, this curve descries a simple line that plots the interest rate paid by similar bonds of different maturities. Normally, the line slopes upward, because longer-term investments are more susceptible to losing purchasing power to inflation, and thus must pay higher interest rates to compensate. An inverted yield curve occurs when short-term rates are higher than long-term ones. This doesn’t happen very often; when it does, it means the market believes the long-term risk of inflation is less than the short-term threat.
A flat yield curve is one in which long-term rates are not significantly higher than shorter-term ones. With this type of curve, you may be able to capture most of the yield of longer-term bonds by purchasing shorter-term instruments. However, that doesn’t mean you should only buy short-term bonds, since that would make your interest income more volatile.
Some people use various strategies to try to outguess the yield curve, but the truth is that it’s impossible, because nobody can accurately predict the future direction of interest rates. Instead of trying to look into the yield curve crystal ball, here are a couple of suggestions:
Buy a bond that matures when you need the money. Suppose, for example, you want a lump sum to help pay for your child’s college education, which will start in 10 years. By purchasing a 10-year bond and holding it to maturity, you will know precisely how much you can expect to receive.
Build a “bond ladder.” If you’re investing for the long term, you may want to consider creating a bond ladder by purchasing a portfolio of bonds of varying maturities. A ladder is a good “all-weather” strategy for any interest-rate environment. If rates rise, you’ll be able to reinvest the money coming due from your shorter-term bonds. And if rates fall, your longer-term bonds will have locked in higher yields than what the market is currently offering.
As a tool for understanding the relationship between interest rates and the market’s expectations for inflation, the yield curve can be useful. But don’t look to it as a guide to making investment decisions. If you want to achieve your financial goals, you’ll need to avoid the “guessing game.”
Carol Perry, a Northern Nevada resident since 1983, represents the firm of Edward Jones Investments in Carson City.