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Investment strategies: Three tips for investing in a flat-to-inverted yield-curve environment

By: Jeff Duesler, Senior Investment Services Representative

Jeff Duesler Déjà vu. The feeling that one has lived through the present situation before. If you spend enough time entrenched in the financial markets, you’ve probably felt déjà vu several times this year, particularly with the recent flatness of the yield curve. For the past several trading sessions, the two, three, and five-year U.S. treasuries have either been inverted or trading at parity, which is reflected in the chart below. (As a reminder, inversion is when the yield on a shorter-term security is higher than a longer term. Parity is when those yields are the same.)

Issue Coupon Maturity Yield
2-Year 2.500% 12/31/2020 2.565%
3-Year 2.625% 12/15/2021 2.548%
5-Year 2.875% 11/30/2023 2.577%

While an inverted yield curve isn’t a foolproof predictor of a recession, it’s close to it. An inverted yield curve predicted the last seven recessions, including the deep recession in 2007/2008. Not to salt old wounds, but while the “financial crisis” hopefully taught us a lesson about limiting and diversifying risk and containing asset bubbles, this same crisis can also teach us how to invest in a flat-to-inverted yield-curve environment.

Under a normal yield-curve environment, the higher the yield, the easier it is to commit to a longer-term investment. In the current flat/inverted yield-curve environment, some investors may ask “Why would I want to invest for five years at 2.63% when I can invest for two years at 2.60%?” While this certainly makes all kinds of logical sense since there isn’t that much difference in the rate (less than 1%), consider some historical context and back-testing.

First, remember that a good, sound investment ladder is typically going to work out the right way and insulate your investments from swings in interest rates. Investment selection at any point in time is part of a holistic portfolio approach. While there’s certainly something to be said for keeping investments short for liquidity purposes, keeping all of your investments short because of the rate environment could result in a game of musical chairs; when the music stops, you’ll be left scrambling to find a chair. This is what happens when you have too many investments that mature in a lower interest-rate environment.

Consider the following comparison of U.S. Treasury yields around this time a few years ago:

December 2007 December 2010
2-Year Issue, 3.30% Yield 2-Year Issue, 0.65% Yield
3-Year Issue, 3.25% Yield 3-Year Issue, 1.10% Yield
5-Year Issue, 3.71% Yield 5-Year Issue, 2.02% Yield

Based on this information, here’s a hypothetical example of the rates to reinvest if the two-year issue was purchased and the five-year issue was ignored:

  • By not selecting the five-year investment in 2007, the investor gave up 40+ basis points up front and an additional 306 basis points at the end. (The investor would have received a 3.71% coupon for two more years in 2010 if the five-year issue had been purchased.)
  • In other words, the investor forfeited a considerable amount of income, approximately $61,200 (based on the two-year rate of .65% and an investment of $1,000,000.00).

While short-term rates might look extremely attractive now versus longer-term rates, they do in fact share the same yields after all. We don’t know for certain if the curve will steepen again and, if it does, by how much or for how long, or what the Federal Reserve Open Market Committee might do next year with regards to interest rate hikes (although the market suggests there will be only two rate hikes, which is down from the four rate hikes last year). Sticking with strategies like laddering will diversify maturities, perform in multiple interest-rate environments, and weather interest-rate fluctuations.

This means that your credit union can consider the following three tips:

  • Put away the crystal ball on predicting interest rates when it comes time to invest.
  • Stay disciplined to a laddered strategy.
  • Ignore how “illogical” it might look to invest three additional years while only picking up 40 basis points.

A colleague once gave me a piece of advice that continues to resonate: “Trade the market you have, not the one you want.” Meaning, if we sit and wait for what might happen or what is supposed to happen, we pass up good opportunities (especially for additional income) right here, right now.

On behalf of the investment department, we appreciate the opportunity to serve you and your credit union’s investment and liquidity needs. Let’s hope for a less volatile 2019, but if there is volatility in the markets, we’re here to help you plan an investment strategy that is prepared for it.