Bond yield curve can predict future
Bond interest rates serve as tea leaves for economists attempting to read into them a hint of future economic conditions. Generally speaking, low long-term interest rates indicate that the economy will be growing slowly and that nobody expects an economic boom anytime soon. The most perilous words for an investor to utter are, “This time it’s different.” Usually it’s not. Economic cycles just repeat themselves over the years in predictable ways. But now, with European governments charging people to invest in their bonds, we are experiencing an interest rate phenomenon that hasn’t existed ever in over 100 years. Practically speaking, this time it may finally be different.
As a general rule, bonds with longer maturities (longer-term loans) have to pay higher interest to offset the fact that something unpredictable now might happen before the bond matures — like a default. Notes, or short-term bonds, pay low interest because investors know the money will be paid back before anything bad can happen. A graph would show interest rates increasing with longer maturities of bonds. In the old days, a rare “inverted yield curve” occasionally showed that short-term notes (money market funds) were paying a higher rate of interest due to demand than longerterm bonds. This meant that corporate borrowers preferred to borrow short term for now because they expected longer-term loans to get cheaper — which, in turn, signaled that they expected the economy and the stock market to stall. This is just one illustration of how interest rates can predict the future.
Today’s yield curve is not inverted. Short term money pays almost zero and ten year U.S. Treasury bonds pay 1.36 percent — the lowest rate in U.S. history. But a very low rate for ten-year money traditionally has meant that the economy is not predicted to grow very fast and inflation will be very low — a pessimistic view. An alternate universe, however, offers a different explanation for why interest rates are so low.
Consider the fact that corporations are awash in more cash than at any time in history. Companies are usually borrowing money, but today they have almost $2 trillion sitting in Treasury bills earning about 2 percent. Apart from just parking their profits, many companies, pension funds, insurance companies, banks and other organizations are required to hold bonds for regulatory reasons, so all this money that could otherwise be fueling growth is just flooding the bond market and driving down interest rates. Today’s low rates, then, may not be the reflection of pessimism that they would have signaled in past economic cycles. It’s just a case of too much supply of money and not that much demand for borrowing.
What this means for investors is that stocks continue to be a profitable investment. The single largest component impacting corporate bottom lines is the cost of borrowing money. If this cost is next to nothing, or a company is funding its credit needs by using its own cash, more profit trickles down to you and me as stockholders. That explains why dividends on a lot of blue-chip stocks are as high as 3 percent or more.
Another wrinkle in this current condition is the fact that lower-rated bonds known as high-yield bonds or junk bonds may be a good option for generating yield and may be safer than the ratings indicate. These bonds are loans to companies that may be better positioned to avoid default in a steady, slow-growth economy. In the meantime, the interest paid on these bonds can be up in the 4 to 5 percent range, which reflects what investors once assessed as the default risk.
The traditional warning to avoid bonds at all costs when rates are low is based on the fact that an existing bond paying a low interest rate will drop in capital market value if interest rates in the market begin to rise. Traded daily like stocks, the value of the old bond has to drop so that its set interest payments amount to the same percentage return as interest on the new, higher-yielding bonds. For buy-and-hold investors, it doesn’t matter, as we hold out until the old bonds are replaced by the new ones paying higher interest.
If we’re waiting for rates to rise, we shouldn’t hold our collective breath. What may make sense in today’s environment of profitable companies and the possibility of long-term steady growth would be large companies that pay dividends and possibly a high-yield corporate bond fund. Be prepared for both to drop in capital value for reasons not now apparent as we peer into the abyss, but reinvested dividends and interest would help pick up the slack.