Trouble With the (Yield) Curve

The yield curve, in its simplest form, shows interest rates at a point in time for U.S. Treasuries with differing maturities.

In normal markets, as the time to maturity increases so does the yield. This is intuitive because interest-rate risk tends to increase with maturity, and investors demand compensation for this risk. Investors' expectations of future short-term rates also influence the shape of the yield curve. If investors believe short-term rates will fall in the near term, the yield curve may become flat, or even inverted, where long-term interest rates are lower than short-term rates. A flattening or inverted yield curve is often interpreted as a sign that the economy is starting to cool and that the Fed may start to lower short-term rates. In contrast, a steepening yield curve usually points to a strong economy with increased inflation expectations.

With all of these variables at work, interest-rate changes are rarely linear. We can break changes in the yield curve into three components: changes in the level of rates (which is usually the most important), slope of the yield curve, and its curvature. The slope of the yield curve measures the difference between short- and long-term yields. When there is a twist in the yield curve, it is becoming flatter or steeper. The curvature of the yield curve can change when short- and long-term rates move more than intermediate-term rates, or vice versa.

In the chart above, the yield curve is considered steep because of the large difference between long- and short-term interest rates. This is partially due to the Fed's decision to keep the federal-funds rate near zero. With fear that the Fed may begin to increase the federal-funds rate, investors should pay close attention to how the yield curve moves.

For example, during the last increase in the federal-funds rate in June 2004, the curve began to flatten. During the next two years, the yield curve continued to flatten and eventually inverted.

This is an important concept because it shows that short-term bond funds are not always the safest investment in a rising interest-rate environment. It is possible that short-term interest rates rise while long-term rates remain the same or even fall. For instance, from February through September 2014, the five-year Treasury yield increased to 1.78% from 1.44%, and the 30-year Treasury yield decreased to 3.21% from 3.55%. During this time period, iShares 3-7 Year Treasury Bond IEI (4.6-year duration) lost 0.41% while iShares 20+ Year Treasury Bond TLT (17.1-year duration) gained 6.36%.

The table below shows that the price performance of a bond fund depends on the interest-rate change of comparable maturity. When a fund's comparable Treasury yield increased, like the two- and five-year Treasury, its price declined. Conversely, when a fund's comparable Treasury yield decreased, like the 10-, 20-, and 30-year Treasury, those funds' prices increased. It's not enough to know interest rates might rise--investors must know what interest rate will move, and by how much.

Corporate Bonds and Mortgages
Corporate bonds and mortgage-backed securities add an additional layer of complexity to interest-rate sensitivity because, in addition to interest-rate risk, investors' tolerance for credit risk also affects their interest rates. These bonds must offer higher yields than duration-matched Treasuries to compensate investors for the risk that the borrower might default. This is known as the credit risk premium.

Much like the Treasury yield curve, corporate-bond and MBS spreads are not always consistent and can move differently across different credit qualities and maturities. For instance, the spreads between the yields of Aaa and Baa corporate bonds during the past 20 years, as measured by the difference between the Moody's Seasoned Aaa Corporate Bond and Moody's Seasoned Baa Corporate Bond indexes' yields relative to the 20-year Treasury, has varied between 0.5% and 3.4%.

Investors might have expected iShares Intermediate Credit Bond's CIU price (4.7-year average maturity) to decline like iShares 3-7 Year Treasury Bond as the five-year Treasury yield increased. However, CIU appreciated as corporate credit spreads continued to tighten relative to Treasuries. While corporate bonds of similar maturity to Treasury bonds generally have smaller durations because of their higher yields, it is possible that they could lose more value if the risk-premium widens. Click here for Morningstar's David Sekera's latest bond market outlook.

Options for Rising Rates
Ultra-short-term bond investors will be protected from most interest-rate changes. While the chance for principal loss is small, investors should pay attention to yield to maturity and costs, which can erode most--if not all--of an investor's returns. For example, SPDR Barclays 1-3 Month T-Bill ETF BIL takes virtually no credit and interest-rate risk. However, its 0.1368% expense ratio is greater than its yield to maturity (0.01%), which virtually guarantees a negative return.

Short-term bond investors should consider investment-grade floating-rate bond funds like iShares Floating Rate Bond FLOT. While traditional fixed-coupon bonds pay a consistent income stream, their prices adjust down when interest rates rise. In contrast, floating-rate bonds' payments adjust with interest rates, so their prices don't have to.

Investors may want to avoid funds in the intermediate-term bond Morningstar Category, like iShares Core U.S. Aggregate Bond AGG, because of their sensitivity to rising rates. While they have less sensitivity to interest rates than long-term bond funds, intermediate-term interest rates have historically increased more in rising interest-rate environments as the yield curve flattens.

While long-term interest rates have historically had little sensitivity to short-term interest-rate increases, long-term bonds still have great sensitivity to even small changes in long-term interest rates. Investors who need access to their capital in the short- to intermediate-term should avoid long-term bonds because of the increased risk of principal loss. They may still be appropriate for long-term investors because the higher coupon payment can help offset principal losses and provide greater total returns in the long run.

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