The current yield on a one-year U.S.Treasury bond is 4%.
But the yield on a ten-year Treasury bond is only…3.5%.
- Why is this?
- What does it mean for retirement savers?
- And how should investors respond?
That’s what I’m tackling today on the show!
How to Listen to Today’s Episode
- Subscribe to the Stay Wealthy Newsletter! 📬
- Stay Wealthy Episodes Mentioned:
- Rising Interest Rates Don’t Mean Negative Bond Returns
- Investing in Bonds Part 1, Part 2, Part 3, and Part 4
- US Treasury Bond Yields [Bloomberg]
- Steepest Yield Curve Inversion in 22 Years [Business Insider]
- What is a Risk-Free Rate of Return [Investopedia]
What Does an Inverted Yield Curve Mean for Retirement Investors
Taylor Schulte: The current yield on a one-year U.S.treasury bond is 4%. But the yield on a 10-year treasury bond is only 3.5%?
Why is this? What does it mean for retirement savers? And how should investors respond?
That’s what I’m tackling today on the show.
To grab the links and resources mentioned, head over to youstaywealthy.com/168.
The risk-free rate is the rate of return offered by an investment that theoretically carries zero risk.
In practice, the risk-free rate of return does not truly exist, since every investment carries at least some risk, even if it’s not in the traditional sense.
But, for U.S. investors, the yield on a short-term US Treasury bond is often used as the risk-free rate.
And that’s because an investment in a US Treasury bill or bond is backed by the full faith and credit of the united states and therefore deemed the safest investment one can make.
For today’s episode, we’re going to use the yield on a one-year US Treasury Bond as a reflection of the current risk-free rate.
As stated at the top of the show, the current yield on a one-year US Treasury Bond (i.e., the risk-free rate) is 4%. This means that if you invest $100,000 into a one-year US Treasury Bond today, you’ll have earned $4,000 when the bond matures in 12 months without taking any investment risk.
On the other hand, if you invest $100,000 into a 10-year US Treasury Bond, you’ll only be earning $3,500 dollars every 12 months for the next decade. And that’s because a 10-year treasury bond is currently yielding 3.5%, half of a percent less than a one-year bond.
So why would anyone buy a 10-year bond if they can earn a higher interest rate on a one-year bond with the same credit quality?
Before we answer that, let’s first quickly address why this happening in the first place. Because, as you might already be thinking, longer-term bonds usually offer a higher yield than shorter-term bonds.
Not all that different than a CD you would buy at a bank. You would expect to be paid a higher interest rate on a 5-year CD than a 1-year CD. You’re locking your money up for a longer period of time (one form of risk) and therefore you would expect to earn a higher rate of return. More risk, more return.
Circling back to bonds, when shorter-term bonds carry a higher yield than longer-term bonds, we call this a yield curve inversion. I’ve discussed this one other time on the show, but this time, the yield curve is experiencing its steepest inversion in over 20 years.
While an inverted yield curve doesn’t guarantee a recession, it is a closely watched indicator of a potential recession in the near- to medium-term.
An inverted yield curve is really indicating that investors expect trouble to be around the corner. That potential trouble (i.e., a recession) often leads to lower interest rates on longer-term bonds, so those investors who are predicting trouble want to load up on long-term bonds before the rates decline. This race to buy longer-term bonds pushes the yield lower than short-term bonds, at least temporarily.
The opposite is also true. When investors expect a period of rapid growth, longer-term bonds will be significantly lower than shorter-term bonds. Lower interest rates are used to encourage spending and investments in the riskier equity markets, both of which can be contributors to economic growth.
Now, even though an inverted yield curve doesn’t necessarily guarantee a recession is around the corner, economic officials often pay close attention to bonds and interest rates and can be influenced to take action when the curve inverts in an effort to try and avoid a catastrophic event. As noted in recent episodes, the Fed is in a tough position at the moment and time will tell if the policy response to the current economic conditions will prevent a recession or at least mitigate its severity.
Until then, investors still have decisions to make with their money. And with the one-year US treasury yielding more than a 10-year treasury, many investors might be wondering what the catch is. Why would anyone buy a 10-year bond? Shouldn’t they just put their bond allocation in one-year treasuries since they’re yielding more?
To help arrive at an answer to these very logical questions, we have to recognize that although treasury bonds don’t contain investment or credit risk, they aren’t 100% risk-free.
For example, if I buy a 10-year US treasury bond yielding 3.5%, I know the exact outcome of my investment every year for the next 10 years and I can build a plan around that. That certainty can be valuable for a certain investor with a certain set of goals.
On the other hand, if I buy a one-year US treasury bond to capture the slightly higher yield of 4%, it’s anyone’s guess what my options will be when I go to reinvest my proceeds in 12 months. What if a one-year treasury in 12 months is only yielding 2% at that time? That previous 3.5% yield on a 10-year bond is now looking pretty attractive to me. In fact, if that were to happen, I may now be tempted to buy a longer-term bond with my proceeds.
Let’s say I buy a 5-year bond with my proceeds because I don’t want to get stuck again in 12 months. But shortly after buying, interest rates spike and now my 5-year bond isn’t looking like such a great choice. You can see how this one short-term decision can spiral into a series of emotional, challenging, and sometimes costly decisions in the future.
My guiding philosophy, in life and in investing, is to focus on things we can control. We can’t control where interest rates will be in the future and it’s impossible for us to know if buying a one-year bond today is better than buying a 10-year bond. This is why I prefer to own and hold thousands of bonds with different maturities over long periods of time, helping to reduce interest rate risk and, maybe more importantly, reduce the odds of me getting in the way and becoming my own worst enemy trying to outsmart the markets.
“Over a long period of time” is a key phrase there. Because in retirement, creating an income stream from our investments for the next 30-40 years is a long period of time. And trying to time the bond market and obsess over how to take advantage of an inverted yield curve to determine what maturity bond to buy next, rarely matches up with the goal of creating a consistent, reliable retirement paycheck for the next 30+ years while also ensuring we don’t run out of money.
There are more important decisions, in my opinion, to be making than how can I take advantage of an inverted yield curve over the next 6-12 months, especially when you can invest in thousands of high-grade bonds through an ETF or mutual fund that costs almost nothing.
Yes, it’s not fun to see the principal value of your bond fund decline here in the short term, but again, we aren’t investing for the short term. Most retirement savers (and retirees) aren’t investing for the next 12 months or even 10 years. A 65 year-old entering retirement today is investing for the next 30 years. And just like stocks, we can’t let short-term events cause us to react and make emotional changes that can have negative long-term impacts.
I’ve previously dispelled the myth that rising rates equals a negative return on bonds and will link to that episode in the show notes if you want to listen again.
It might also be a good time to revisit my 4-part series on investing in bonds. I’ll be sure to link to that in the show notes as well which can again be found by going to youstaywealthy.com/168.
Ok, two final things I want to touch on before we part ways today.
First, I want to point out what the current state of the bond market and, specifically, the risk-free rate means for your overall investment plan going forward.
The risk-free rate, the 4% you can earn on a one-year treasury bond, should be your current starting point today for any investment you’re considering. In other words, if you’re going to take any risk with your investments, you’re going to expect something more than 4%. This means that riskier asset classes like stocks should have higher future expected rates of return today than they did yesterday or a few months ago. Otherwise, nobody would invest in them.
Nobody would invest in riskier asset classes if they didn’t expect a return that properly compensates them for the risk they are taking above and beyond US treasuries. So, keep this in mind as you evaluate your asset allocation and financial plan and look to make any necessary investment changes going forward. Just take note of how quickly interest rates can move.
The one-year treasury is yielding about 4% today, and that might be your starting point today, but that can change tomorrow or next month. So don’t latch onto this 4% number we’ve discussed today.
Second, while the uptick in short-term interest rates may not change your long-term asset allocation decisions, it may present an opportunity to improve your cash management strategy. To put this opportunity into perspective, the one-year US treasury was yielding 0.40% at the end of 2021. At the same time, the annual headline inflation rate was around 7%.
Today, the risk-free rate is in that 3-4% range, and annualized headline inflation sites around 8%. So if your cash is managed appropriately, you’re able to better protect your purchasing power today given higher interest rates.
Unfortunately, it takes some extra effort to do so because the big banks you know by name aren’t passing these higher interest rates off to their customer. You’ll either need to leverage an online bank like Ally or Capital One or consider buying individual US Treasuries as a cash alternative. Just remember, that unlike an FDIC money market provided by an online bank, US treasuries do fluctuate in value day-to-day. So, if you buy a one-year treasury as a money market alternative, you’ll want to commit to holding it until maturity.
Ok, that’s a wrap for today. Once again, to grab the links and resources mentioned in today's episode, just head over to youstaywealthy.com/168.
Thank you, as always, for listening and I will see you back here next week.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.