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Investing in Bonds with a Flat to Inverted Yield Curve

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KATHY JONES: For most of the past six months, the yield curve has been either flat or inverted. That is, short term interest rates have either been the same as long term interest rates, or actually higher than long term interest rates. Now, that’s caused a lot of investor concern because an inverted yield curve is a reliable signal of recession and it also makes investing in bonds more difficult.

When the yield curve is flat to inverted, investors are often tempted to sit in very short-term investments like cash or treasury bills, say, with maturities of under a year because they’re going to get as much or maybe more yield in those investments than they would taking on some of the duration risks of longer-term bonds. But there are a couple problems that come with that.

First of all, you need to consider what your time horizon is when you’re investing in fixed income. If your time horizon is longer than a year, you should really endeavor to match up your investments with the time that you’re going to be invested, so that you have a steady income stream over time.

A second consideration is the benefit of diversification you get from having high-quality bonds in your portfolio. So, if we were to hit a downturn in the stock market, bonds that are high in quality, such as treasury bonds or highly-rated municipal bonds, can provide that ballast and stability in an overall portfolio when the markets get volatile.

And the third consideration is that not all of the yield curves in the bond market are actually flat to inverted. For example, the municipal bond market’s yield curve is actually positively sloped. What that means is that the yields are higher for every year of maturity as you go out in time. So, for investors in higher tax brackets, it may be worth considering looking at the municipal bond market, particularly bonds with very high ratings like AAA or AA, as an alternative to treasuries for those longer-term investments.

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When the yield curve is flat to inverted, fixed income investors are often tempted to sit in very short-term investments because they’re going to get as much or maybe more yield in those investments than they would taking on some of the duration risks of longer-term bonds. On this episode of Bond Market Today, Kathy Jones explores some of the issues that come with that.

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