The Yield Curve Presents a Sweet Spot

Every once in a while, the market gives you a trade with a lot of outs, something that can work for a variety of reasons. I believe that owning shorter, high-quality bonds vs. longer bonds and/or cash is one of those trades.

The yield curve slope is currently very steep between cash securities and both two-year and five-year bonds. In other words, the yield differential garnered by moving from cash to two-to-five-year bonds is significant. In the Treasury market, one-month T-bills yield about 1.25%, whereas two-year bonds yield about 2.30% and five-year bonds about 3.05%.

In "government" agencies, one-month yields are in the 2.20% area, vs. 3.20% for two-year bonds and 4.00% for five-year bonds. In tax-exempt municipals, cash-equivalent bonds yield about 1.35% right now, vs. 2.50% for two-year securities and 3.17% for five-year bonds.

In order for the cash-equivalent bond to outperform two-year bonds over the next year, short-term rates would have to rise substantially. For example, assume one investor buys a one-month tax-exempt municipal at a 1.35% yield today and rolls that over every month for one year. The other investor buys a two-year municipal at 2.50%. Assume that starting six months from now, short-term interest rates start to rise, with both two-year and one-month rates rising at the same pace. It would take a 0.96% increase in rates for the total return on the two investments to equate. Anything less, and the two-year bond wins the day.

In addition, one needs to consider the concept of rolling down the curve. When the yield curve is steep, the inevitability of time passing results in price appreciation. In other words, as a five-year bond ages and becomes a four-year bond, the yield drops (price rises), simply because four-year bonds yield less than five-year bonds. Using tax-exempt municipals, the yield difference between four- and five-year bonds is currently 15 basis points, which is worth 0.56% in price appreciation.

Now, let's consider the possible paths that markets may take in the near term. First, its possible that "fear trades" continue to be the rule. In this case, rates aren't likely to rise by much, especially in the five-year area. In fact, it would be more likely that two-to-five-year rates would fall as investors warm up to the idea that the Fed will be on hold for an extended period.

Second, it's possible that there is a relief rally after bank earnings are out. Maybe the results aren't as bad as people fear, and more banks have adequate capital than not. In this case, all rates are likely to rise, so most bonds will probably lose money. But those who are invested in longer-term bonds lose more, whereas investments in the middle part of the curve are somewhat sheltered.

So from a risk/reward perspective, investors holding on to either cash or longer-term bonds will probably perform better moving into the two-to-five-year area of the yield curve.

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Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment advisor in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.