Careful On The Curves

6/9/2014


Have you been following the gyrations of the yield curve?

Most stock investors would probably answer no to that question. The curve reflects how the yields of Treasury bonds increase as the maturities move further out. For example: Over the last 18 years, 10-year Treasury bonds have averaged yields 1.14% higher than those of two-year bonds, while 30-year Treasurys averaged yields 0.43% higher than 10-year yields.

Long-term bonds tend to pay higher yields than short-term bonds because they are more volatile. The longer the period until the bond matures, the more interest-rate risk investors must endure, thus the more yield required to compensate for that risk.

Over time, the yield curve can shift up or down, with yields for bonds of all maturities rising or falling. The curve can also steepen (widening the spread between yields on short-term and long-term bonds) or flatten (narrowing the spread).

The yield curves today, at the start of this year, and at the start of 2009 look similar. All reflect periods when the Federal Reserve held the short portion of the curve anchored near zero. The Fed has kept the target fed funds rate below 0.25% for more than five years; it had never dipped that low during the previous 55 years. The curve from 1994 is closer to the norm, as the Feds' anchoring of short-term rates near 0% in recent years has made the long end of the curve move without corresponding movement at the short end.

Between the two-year and 30-year maturities, today's curve (2.94% spread) is far steeper than the long-run average (1.49% spread) despite unusually low yields on long bonds. The spread has tightened since the end of 2013 and is below the five-year average of 3.22%.

Unusually low Treasury yields have made corporate bonds look relatively attractive throughout most of the economic recovery. Over the last five years, Baa-rated bonds averaged yields 2.9% higher than 10-year Treasurys, well above the long-run average of 2.3%, paying investors an extra premium for taking on default risk. However, the spread narrowed during the second half of 2013 and has now dipped slightly below the long-run average.

What does the activity of the yield curve mean to you as an investor?

Economic growth: A steepening yield curve is often seen as a signal of an improving economy. The spread between the two-year and 30-year Treasury yield is down slightly from the average over the last five years but is still roughly twice the long-run average. Given the U.S. recovery from the Great Recession, the steeper curves of the last five years make sense.

Market action: Before the start of bear markets, yield curves tend to not only flatten but invert, with short-term rates exceeding long-term rates. Inversion tends to occur when investors expect a dip in short-term rates, and in response rush into longer bonds. Today's curve isn't close to inversion, though the Fed's control of the short end of the curve calls into question the value of that signal.

Interest-rate expectations: Yield curves tend to steepen when investors expect short-term interest rates to increase. This trend seems to explain why the yield curve steepened in 2013 on fears the Fed would raise rates, then flattened somewhat in 2014 after the Fed reiterated plans to keep rates low for some time. All else equal, low interest rates are good for stocks because they keep borrowing costs manageable, though today's interest-rate environment has no reliable precedent.

Inflation: Yield curves tend to be steep when inflation is expected to rise in the future, so steeper curves over the last five years should point to higher inflation. However, while inflation has picked up over the last six months, it remains below 2% as measured by the Consumer Price Index, in line with the high from July 2013, slightly above the five-year average of 1.7%, and below the 20-year average of 2.4%.

Bond price action: Bonds of all stripes generally lose value when the yield curve floats higher. Conventional wisdom holds that bonds are doomed to weakness because short-term rates have nowhere to go but up. However, millions of bond investors know higher rates are in store, and with the yield curve already steeper than usual, the effect on long bonds is tough to predict.

If the trends presented above seem contradictory or inconclusive, you got the picture. Yes, changes in bond yields matter. But boilerplate answers about how interest-rate changes affect stock and bond prices are usually simplistic and often wrong.

Our take: Pay attention to interest rates, but don't overreact to the latest headline, even if the broad market does. Such moves often reverse once investors digest the news.

Stocks look good relative to bonds in part because they're cheap relative to bond yields. The median S&P 500 Index stock has an earnings yield (earnings/price) of 5.2%, more than 2.7% above the yield of 10-year Treasurys and 1.1% above the yield of Aaa-rated corporate bonds. Since 1994, the median S&P 500 earnings yield has averaged just 1.2% higher than the 10-year T-bond yield and 0.3% below corporate bonds. Stock price/earnings ratios would have to rise 35% to 45% to bring the spreads back to historical norms.


A less-taxing alternative

Interest on municipal bonds, issued by states, municipalities, and quasi-governmental entities such as airports and water systems, is generally immune from federal income tax. When comparing muni bonds to taxable bonds, we typically adjust the stated yield based on the highest individual income-tax rate (39.6%) to compute a tax-equivalent yield comparable to the stated pretax yields of taxable bonds.

Even without their tax advantages, munis look better than usual relative to other bonds.

As of May 29, The Bond Buyer's 20-Bond Index of municipals yielded 4.26% (equating to a tax-equivalent yield of 7.05%), down from 4.73% at the start of the year but roughly in line with the five-year average of 4.25%. The current yield lags the 20-year averge of 4.91%, no surprise given the Fed's anchoring of the yield curve at the short end.

At the moment, municipal bonds look somewhat expensive relative to their 20-year average yield. However, Treasury and corporate yields have fallen more sharply from long-run averages, making munis appear cheap in comparison. Over the last 20 years, Baa-rated corporate bonds have averaged a yield 2.06% above that of the 20-Bond Index. However, that spread shrank to an average of 1.29% over the last five years and 0.34% as of May 29, the tightest spread in at least 60 years.

Our take: We prefer stocks to bonds for the year ahead. But if bonds make sense for you, municipals look like a wise choice — assuming you keep your bonds in a taxable account and can take full advantage of munis' tax protection. Investors seeking exposure to municipal bonds should look at the Vanguard Intermediate-Term Tax-Exempt ($14; VWITX) fund, with a tax-equivalent yield of 3.0%. The table below lists six national municipal-bond funds that earn high scores in our rating system. All have topped the average return for their group over the last one and three years. All pay above-average yields and charge below-average expenses.

Interesting municipal-bond funds
Tax-
Equivalent
Yield
(%)
------ Total Return ------
-- Annualized --
Municipal-Bond Category
Mutual Fund (Price; Ticker)
12
Months
(%)
3 Yrs.
(%)
5 Yrs.
(%)
Expense
Ratio
(%)
Fund
Rating
Short-term
Fidelity Ltd. Term Muni. Income
($11; FSTFX)
1.1
1.4
2.1
2.6
0.48
93
USAA Tax Exempt Short-Term
($11; USSTX)
1.1
1.0
2.1
3.0
0.55
100
Intermediate-term
Vang. High-Yield Tax-Exempt
($11; VWAHX)
4.8
3.3
6.6
6.9
0.20
98
Vang. Interm-Term Tx-Ex Inv
($14; VWITX)
3.0
2.9
4.7
4.9
0.20
92
Long-term
Fidelity Tax-Free Bond
($12; FTABX)
4.0
3.4
6.1
6.0
0.25
94
Vang. Long-Term Tax-Exempt
($12; VWLTX)
4.3
3.6
6.1
6.0
0.20
92
Source: Morningstar.

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