Why bonds in an inverted yield environment?

While the interest rate hike has been a bummer for the stock market, bond prices, and home buyers, it's been pretty awesome for savers. That said, short-term savings have higher interest rates than intermediate- and long-term bonds, which is unusual, and raises some interesting questions -- questions that need answering.

What, exactly, is an "inverted yield environment", and why is that special?

First, let’s take a look at the yield curve from a couple months back (comments courtesy of XY Investment Solutions):

As a quick reminder: what this is saying is that last year, 3-month treasury bills were yielding a little above 2%; since then, they've shot up to around 5.5%. But while last year, 5-year treasury bonds were yielding around 3%, currently they’re yielding just a little over 4%. And not pictured: as of 6/30/23, money market funds are yielding around 4.8%.

Given all that, I’m hearing several people say something along these lines: “if money market funds (4.8%) are yielding so more than 5-year bonds (4%), why bother with bonds? Why not move our bond funds to money market funds, or at least one-year bonds, until intermediate-term bonds are yielding more than money markets?”

The answer comes in the form of some fancy jargon: “pure expectations theory”, combined with the “maturity risk premium”.

Pure Expectations Theory

Pure expectations theory says that market expectations of future interest rates are baked into current yields, such that, assuming the market is correct, you’ll get the same amount of interest over time no matter what you do. (There are some issues with this, but it’s useful for this conversation; we’ll talk about one of the major issues in a bit.)

So for example, let’s say that 1Y (one-year term) bonds are at 5.5%, 2Y bonds are at 5%, and 3Y bonds are at 4.5%. This isn’t saying that 1Y bonds are yielding 5.5% now, then will yield 5% next year, then 4.5% the year after, or something like that; rather, according to pure expectations theory, it’s saying that this time next year, 2Y bonds will be yielding 4% -- much lower than where they are now! Again, this assumes the market is correct.

(How did I get 4%? The math looks like this:

Current 3Y interest for 3 years = Current 1Y interest * Next year 2Y bond for 2 years

(1.045)^3 = (1.055)*X^2

X^2 = 1.14 / 1.055 = 1.082

X = 1.04 = 4% yield

)

If the math is hard to follow, here's the upshot: according to pure expectations theory, if you move from 3Y bonds to 1Y bonds (or 3-month bills or a money market fund), it doesn’t get you anything -- you get more yield now, but you get so much less yield later that you may as well have stuck with 3Y (or 5Y) bonds.

“But wait”, you say, because even if you didn't follow the math, you’re smart and you’ve spotted an issue with the theory. “If I’m going to earn exactly the same amount of interest whether I invest in 3m bills or 5Y bonds, why bother with 5Y bonds at all?”

Maturity Risk Premium

The answer is: maturity risk premium, or MRP. Because in general bonds with longer maturities have higher volatility (because interest rates have more of an opportunity to change over time), there’s less demand for them, which means that their price is lower, which means the yield is higher than it would be according to pure expectations theory. Another way to think about it is this: bond sellers have to offer a better yield in order to entice people to take the risk in buying longer-maturity bonds.

So: in general, assuming efficient bond markets, you can expect higher-term bonds to earn more interest over time than shorter-term bonds, no matter the shape of the yield curve. (There is some nuance here that I’m glossing over, but it’s true enough for this conversation.)

Issue #2 with pure expectations theory, which you’ve no double spotted, is the phrase “assuming efficient bond markets”. If you look at the yield curve above, you can see that last year the market was expecting one-year bonds this year to yield a little less than 3%; clearly that’s not what happened. My response is this: when I say “efficient”, that doesn’t mean “always 100% accurate”, just like when I say “expected” that doesn’t mean “guaranteed”. However, it does mean “accurate enough that betting against it will lose much more often than win”.

In other words: while the pure expectations theory isn't strictly accurate, it is true enough to be useful, particularly with regards to understanding why it makes sense to invest in bonds even in an inverted yield curve environment.

So...what do I do when the yield curve is inverted?

Bottom line: unless there’s something really unusual happening -- like when I-Bonds (which aren't sellable on an open market, and thus don't obey market rules), had a guaranteed short-term interest rate of 9% (!!) for a while -- I generally won’t recommend that you change your overall bond/cash strategy in response to changing interest rates in and of themselves. You know the drill: cash is for short-term needs, bonds are invested according in a diversified portfolio whose asset allocation matches your risk tolerance and risk capacity.

Full disclosure: the bond funds Seaborn clients invest in do change their tactics slightly in different yield curve environments, tilting towards factors of increased return in a manner somewhat similar to how we manage our stock portfolios. But this is a tilt, a minor optimization -- we definitely don't move into and out of cash depending on what the yield curve is doing!

Hope that clears things up, and if it doesn't, don't hesitate to drop me a line!

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.