No curves thrown here: investors can run to the yield cure to get the scoop on the bond market

Black Enterprise, Feb, 1998 by Lynnette Khalfani

Okey, so we all know there's no 100%, on-the-money way of correctly predicting the future, right? Well, would you settle for 50%? Of course, no investment strategist in the world has a crystal ball that can point to exactly what stocks or bonds will do. But, if there is anything like a window onto the future, it's the yield curve, something that makes bond investing more understandable as well as predictable.

The yield curve is a graph like the ones we all studied in geometry. The maturities of government bonds are plotted on the x axis, the yields, or interest each bond pays, on the y axis. Normally, the curve slopes upward much like a hill because bonds with longer maturities--say five, 10 and 30 years out--usually must pay greater interest. You see, a bond's yield is fixed until maturity. Therefore, over time it's vulnerable to changes in the economy, especially the rise and fall of inflation. If inflation is zero, a bond yielding 6% seems like a good investment. If inflation is 3%, a bond yielding 6% loses value, and is effectively paying you just 3% on your money.

Look a little further into the bond curve, experts say, and you can get a good picture of where interest rates are going, and how the broad market expects the economy to perform. First, though, we'll explain some of the lingo you might hear on TV or in financial publications whenever professionals interpret the yield curve. When an expert talks about a "steep" yield curve, he or she means there's a wide spread between short- and long-term rates. For example, the two-year Treasury note might be at 5.5%, while the 30-year Treasury bond might be yielding 7.1%. In other words, investors willing to take on the risk of a longer maturity will be handsomely compensated. By contrast, if the yield curve is "flat," there's less of a difference in the interest paid by two-year bonds and 30-year Treasuries. In this case, short-term bonds could be yielding, say, 5.8%, and the 30-year or "long-bond" could be at 6%.

The 1997 year-to-date average for the spread between the two-year and the 30-year is about 50 basis points, or 0.5. (A basis point is fixed-income lingo for 1/100 of a percent.) Plot that on a graph, and you'll see a line sloping very gradually from the yield of a two-year Treasury, about 5.7%, to that of a 30-year bond, about 6.2%.

THE CURRENT MARKET

Today's flat yield curve signals moderate to slow economic growth and expectations for lower inflation--both of which are better for long-term bonds, according to Mark Lay, chairman and CEO of MDL Capital Management Inc. in Pittsburgh, an investment firm that manages nearly $500 million in fixed-income securities. "With inflation at low levels and interest rates relatively high, yields are therefore looking historically high," he says. "All told, we see that as a sign that longer maturities are a good value right now."

Before you decide on whether to invest in short- or long-term bonds, Lay recommends that you first check out the yield on the Fed funds rate, a benchmark for bond investors, which is currently 5.5%. According to Lay, two-year Treasury notes typically trade about 75 basis points, or .75, above the Fed funds rate. Currently, though, two-year Treasuries are trading at about .25, a sign there's "no value in the shorter bonds," says Lay.

Meanwhile, Lay says longer maturities currently look like a bargain, even after yields on the 30-year Treasury have fallen from 6.7% to 6.05% recently. Lay, who notes that the 30-year Treasury has historically paid 5% interest, says long-term rates should decline from current levels. "In my opinion, long-term interest rates are going to go down dramatically as inflation fears subside here in the U.S., and as the balanced budget agreement limits Uncle Sam's need to borrow," he says. "During the coming year," he predicts, "30-year interest rates should fall to around 6%, if not lower."

If Lay is right, you'll get a whole lot more bang for your buck with long bonds, or those that mature in 10 years or more. But remember one thing before you buy: experts say it's best to invest money you're trying to protect from losses in short-term Treasuries because bonds that mature in 10 years or less typically incur less risk. Also, it's good to choose a maturity that ties into a specific goal you have in mind--say paying for your kid's education in 10 years.