Bonds: The Long and Short of It

Pity today’s fixed-income investor. In the current ultra-low interest rate environment, finding a bond with a yield that outpaces inflation — let alone one that generates enough income to live off of — is not an easy task. One must either fish in the murky waters of “junk” — those issues considered non-investment-grade that are rated BBB or lower — or lock in long maturities.

At least that’s what traditional wisdom says. But the latter option — going longer — is becoming increasingly risky. As rates plumb ever-greater depths, interest rate risk — the risk that rates will rise and bond prices will fall — goes up. With rates on many recent corporate issues under 3% (and U.S. Treasury yields well below that), there is little place for rates to go but up. Given Federal Reserve policy statements and the tepid pace of current economic growth, a rate increase is unlikely to happen in the immediate future. However, most analysts agree that it is just a matter of time before rates do start to rise. The only question is when.

There’s also the matter of spread. The spread between yields on short- and long-term issues has narrowed over the past year and a half. For instance, the spread between one-year and 30-year U.S. Treasuries decreased from 4.32% in January of 2011 to 2.40% in July of 2012. Likewise, the spread between 1-year and 30-year interest rate swaps versus LIBOR shrunk from 3.85% to 1.93% over the same period. These compressed spreads leave little incentive for investors to go with longer maturities.1 And then there’s inflation to consider. Rates on many issues are not even high enough to outpace inflation. In fact, many recent issues have negative “real” yields — those that have been adjusted for inflation. Consider that the inflation rate (as measured by the Consumer Price Index, or CPI, over the past year) is currently hovering at 1.7%, well above rates offered on U.S. Treasuries with maturities of up to 10 years. Also consider that the current rate of inflation is low by historical standards; the CPI averaged 3.0% for the 30 years ended December 31, 2011, and has been as high as 6.1%.2

So what is our beleaguered fixed-income investor to do? He could take his chances with low-rated issues, many of which do offer tempting yields. But these carry greater risk — some significantly greater — which is what most fixed-income investors look to avoid.

Alternatively, he could just stay short, which is exactly what many of today’s bond investors are doing. This means living with very low yields, but it does limit exposure to rising rates and leaves opportunity to buy into longer maturities when rates do eventually rise.

Of course neither of these options is likely to please our fixed-income investor, who might best be advised to contact his financial advisor and see if there are other options available for his particular situation.


1Source: The Federal Reserve. The Treasury spread is the spread between 30-year and 1-year Treasuries. The swap spread is the spread between 30-year swaps and 1-year swaps versus LIBOR, as reported to the Federal Reserve by the International Swaps and Derivatives Association.

2Source: Bureau of Labor Statistics.

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