Editor's Note: This is the third of a three-part Booyah Breakdown series on bonds.
The Booyah Breakdown has been on a mission to decode the bond market.
through the bond basics
-- face value, interest rate and yield -- and then we talked bout how a
bond's interest and price changes
in the market.
So it's now time for our grand finale -- that disturbing inverted yield curve.
Yield for the Yield
First, let's revisit a bond's yield.
The yield on any investment is basically the annual rate of interest return. That's your annual cash inflows divided by the price of your investment, shown as a percentage.
So let's say you buy a $1,000 bond with a 5% interest, or coupon, rate. That means that you will receive an annual payment of $50. But what if you don't buy the bond at face value? What if the company recently came out with bad earnings news and the bond's price slips to $800? How much is the yield then?
Divide your payments by your price (50/800 x 100) and your bond is actually yielding 6.25%. That lower price increases your rate of return. In other words, the price and the yield are inversely proportional -- the yield goes up when the price goes down and vice versa.
So now 6.25% ends up in your wallet instead of 5%! Yippee!
Well, that yield number also ends up on the infamous yield curve.
Oh So Curvy
The yield curve is basically a graph for geeks. Picture a big letter L. Up the left side, a.k.a. the y-axis, is the bond's yield. Across the bottom, the x-axis, is the bond's maturity date. Bonds with different yields and maturity dates are plotted accordingly on this graph and create the yield curve.
The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. And it should be an ascending arc. That would mean that short-term bonds have a lower yield than long-term bonds of the same credit quality, hence the upward slope.
That's because if you buy a longer-term bond, you take on more risk so your interest rate should be higher to compensate you for that exposure to potential defaults, changes in interest rates, etc.
That kind of curve makes all the pundits very happy and is sometimes referred to as the "positive yield curve." Basically, we all like to see things going up (and staying up) in the future.
Ok, so now on to this inverted yield curve that we've been hearing so much about lately.
The curve, pictured below, is inverted when it looks like a ski slope. That means the interest rate -- or yield -- is higher on short-term debt than long-term debt. It's pretty rare, which is why all the pundits have their calculators in a tizzy.
There are a few reasons for the anomaly. A lot of foreign investors are pouring money into our bond market these days because the rates are still good and the dollar remains weak. So foreigners sell their currency for our dollars, invest those dollars into our bond market and make a nice steady chunk of change.
Another reason for the inversion is the market's perception of where interest rates will go. "The market is betting that the
next move will be to lower rates," says Charles Jones, professor of finance and economics at the Columbia Business School.
Here's why: If the short-term rate is hovering at 5%, and the long-term rates are around 4.75%, you'd be leaving money on the table if you went with a long-term investment. On the other hand, if you believe the Fed is going to lower those short-term rates in the near future anyway, you'd have no problem buying that long-term bond.
A bigger reason for the nervousness is that in the past, inverted yield curves have preceded U.S. recessions. Historically, says Jones, every recession has been preceded by an inverted yield curve. However, not every inverted yield curve leads to a recession (there have been more inverted yield curves than recessions).
Because of that, many look to the yield curve to get a sense of what the bond market might be saying about future economic activity.
At this point, though, the bond market is a bit confused. It's not sure if the inverted curve is because of pending recession or all the foreign money coming in to our market.
Should You Care About the Curves?
So how does this so-called inverted curve affect your wallet?
Recession possibilities aside, this inversion does hit home. To start, if you have an adjustable-rate mortgage, your rate changes based on short-term interest rates. So if the short-term rates are higher than the long-term rates, your mortgage payment will increase. You might consider getting yourself into a longer-term fixed loan.
The same goes for the interest rate on your line of credit. It varies with the short-term rates. So pay attention to it.
Increasing loan payments clearly has a negative effect on the overall economy. If we're putting more money toward our interest payments, we're not spending it in the marketplace, and that's not so good.
And this inverted curve affects companies as well. Your company will feel the pain of those higher short-term rates, which could hurt overall profit margins.
So while no one is really sure if this inverted yield curve is a Magic 8-ball predicting doom and gloom this time, we do know that it has some obvious affects on our cash flow. So for now, try to choose investments with the highest yield.
And when our inverted curve transforms back into its ski-slope former self, which it will, just be sure to adjust your portfolio accordingly.
See, curves do matter.
Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on CBS MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback;
to send her an email.