Trading the Yield Curve

broadway bull

By The Financial Lexicon

Over the past couple years, with yields on Treasury securities near historic lows across the curve, I’ve often read and heard financial pundits argue that investors should shy away from intermediate to longer-term Treasuries.  The argument made is that as interest rates eventually head higher over the coming years (no exact time frame is usually given), investors who purchase, for instance, a 10-year U.S. Treasury note, will lose money on that investment.

While it is true that interest rates and bond prices are inversely related, it is not necessarily true that an investor purchasing a 10-year Treasury note today will lose money over the coming years if yields go higher.

How is this possible?

This is where the yield curve comes into play.  The yield curve depicts the relationship between interest rates and the time to maturity on a bond (or related security).  Essentially, the yield curve expresses the market’s expectations of future interest rates.

Currently, along with historically low interest rates, we are also experiencing an incredibly steep yield curve.  The 2-year Treasury note is at 0.23% (23 basis points), and the 10-year Treasury note is at 1.98% (198 basis points).  The 175 basis point differential between the two provides an opportunity for investors.  With this in mind, let me ask the following question:

If you purchase a 10-year Treasury today at 1.98% and the 10-year rate rises to 3% over the next five years, all else remaining equal, how much money will you have lost on a mark-to-market basis?  The answer:  zero. In fact, you will actually have an unrealized gain on the investment, in addition to the interest you would have accrued on a daily basis since purchasing the note.  How can this be?  The steepness of the yield curve, with its embedded hedge, has protected you.

Here is an example of recent yields on Treasury notes:

yields

The 5-year note (technically 4 years, 10 months) is currently yielding 0.82%.  In order for the purchaser of a 10-year note at today’s 1.98% (technically 9 years, 10 months) to have an unrealized loss on the investment (ex-interest earned) five years from now, the 5-year Treasury note would have to rise by roughly more than 1.16% (116 basis points).  This would take the 10-year from today’s 1.98% to 3.14%.  In other words, for the purchaser of a 10-year note at today’s 1.98% to experience an unrealized loss five years from now, the 5-year note would have to rise above 1.98%; and, given the current state of the yield curve, the 10-year note would end up around 3.14%.  The 116 basis points of steepness in the curve between five and ten years to maturity is an embedded hedge and provide some protection to the purchaser of a Treasury security.  In addition, there is added protection to the original principal from the interest payments received on the investment over the years (minus taxes paid on the interest).

Please keep in mind that a steep yield curve isn’t a foolproof hedge against rising interest rates, and the steepness of the curve can change.  Therefore, if rising rates are a concern of yours, depending on your view of how high rates will go and your view of what will happen to the steepness of the yield curve, today might be an acceptable entry point or it might be a terrible entry point.

In future articles, I will discuss the different ways the yield curve’s steepness might change and how investors could think about the effects those changes might have on their bonds.

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