Curves Ahead: Yield Curves and Bond Strategies Made Simple
Fixed-income investments are interesting not only as investments but also as a yardstick for the economy. As you learned earlier in the chapter, interest paid on bond investments is different based on the investment's term to maturity, generally moving higher as maturity increases.
The Yield Curve
Check a list of bond investments with different maturities — such as on the CD rate board at your bank or where bond rates are posted online — and you'll notice that the more years into the future the bonds mature compared to today, they generally carry higher interest rates. But that's not always the case. They can have lower interest rates or remain the same years from now as they are today. This pattern over time, if you charted it on a graph, would create what is called a yield curve.
Investing when It's Positive
A normal growing economy would show a positive yield curve, in which interest rates gradually step higher for longer-term investments. The curve drawn out on paper slowly slopes upward toward higher rates as the line moves up the time line. Investors in this case know that in five or ten years the economy will be larger and salaries and prices will be higher, and therefore they need higher interest to maintain their buying power. Investing in this circumstance is easy with a simple bond ladder.
Investing when the Curve Is Flat or Downward
An economy at risk of recession or with other problems will show a flat or downward — negative — yield curve. In these cases, investors aren't insisting on higher interest rates in the years ahead because the economy is pointing toward contraction, with the likelihood of lower or stagnant prices. Investing in this environment is tricky because bond ladders don't work.
Mutual funds or ETFs are far more appealing when the yield curve is flat or turned south, because you can sell and change your strategy when the market rebounds. They are liquid and you're not locked in.