Analyzing the Correct Curve
By Drew O’Neil
As you read through articles and listen to commentary from the financial press, it is important to not generalize observations that are intended to comment on something specific. Much of the attention recently has been given to the shape of the yield curve and how it has flattened a great deal over the past several years. Investors can interpret this many different ways, but a common question that we get is whether or not anything other than very short maturity bonds should be considered. While there is no blanket strategy that is appropriate for every investor, for a majority of people who are looking for a portfolio of individual bonds to be a long-term principal preservation and predictable cash flow producing piece of their portfolio, the answer is often “Yes” for multiple reasons.
One major reason is that while most of the market commentary is on the Treasury curve, most investors are not investing in Treasuries. When analyzing where to invest, where the value is, what yields can be achieved, etc., it is imperative to assess the relevance of the data being considered. If you are looking to invest in municipal bonds, for example, analyzing the shape of the Treasury curve is not necessarily applicable. The same applies for corporate bond investors… why would you let the Treasury curve determine where you should position your portfolio on the corporate curve? While interest rates across all sectors are interconnected, each market also has its own dynamics that are going to set it apart from other asset classes. The graph below highlights this point.
As you can see, the Treasury curve is very flat, with a 1 to 10 year yield spread of just 35 basis points (bp). The corporate and municipal curves are a different story. The corporate curve has a 1 to 10 year spread of 99 bp, making it nearly three times as steep as the Treasury curve. The municipal curve (looking at taxable-equivalent yield for the 37% tax bracket) currently has a 1 to 10 year spread of 124 bp.
When deciding whether or not to move out into longer maturity bonds, the analysis often comes down to determining if the additional reward is worth the added risk. When a curve is very flat, less “reward” (i.e. yield) is gained by moving out an additional year… or two… or 10 on the curve. The steeper the curve gets, the more “reward” an investor receives by moving out further on the curve. As the graph above conveys, both the municipal and the corporate curves are rewarding investors in the intermediate and long term ranges. Every investor has a unique set of goals and risk tolerance, so each individual’s ideal allocation is going to be different, but when making any investment decision, it is important to make sure that you are basing your decisions off of the appropriate set of information and not taking generalized market commentary and applying it to a specific case where it may not apply.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.