What You Should Know

The normal yield curve (Figure 3.2) shows rates gradually rising as maturity lengthens. This curve can be steeper if investors see more risk in longer-term securities, typically in inflationary times or times where other risk factors like corporate defaults come to the forefront. The yield curve typically flattens (Figure 3.3) when the Federal Reserve raises short-term interest rates to slow the economy, and can even go to an “inverted” state (Figure 3.4), where short-term yields exceed long-term yields, if the Fed acts strongly to restrict money supply. Economists see an inverted yield curve as a sign of a looming recession if the economy cools, as the Fed apparently desires.

Figure 3.2 Normal Yield Curve

Figure 3.3 Flat Yield Curve

Figure 3.4 Inverted Yield Curve

You can watch the yield curve by observing short- and long-term Treasury security and other rates in the financial section of a newspaper or websites. The U.S. Treasury publishes yield curve data (not a chart, unfortunately) at www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml.

On July 1, 2013, the following rates were posted on this Treasury webpage:

View a text version of this table

It’s not hard to see that these rates, although ticked up slightly from earlier in the year, are still historically low. It’s also not hard to see that for income-oriented investors, this is a grim story—while if you’re a borrower, this is attractive, although since you’re not the government, you don’t get to borrow at these exact rates. In fact, especially at the “short” (time to maturity) end of the curve, by the time you consider inflation, you’re really paying the government to hold your money for you.

If you’re an active income-dependent investor, you’ll want to watch these numbers carefully, and if you’re a numbers kind of person in general, it’s interesting to watch these figures fluctuate.

Why You Should Care

Aside from the economic signals it sends, the yield curve also helps you figure out the best “deal” for your money as a depositor or borrower. If the yield curve is relatively flat or inverted, it is best to look for shorter-term CDs or other time deposits; likewise, it’s a better time to look for a longer-term, say a thirty-year, mortgage. If the curve is normal and steep, a thirty-year mortgage will cost significantly more, and you’ll do better if you can stretch your payment into a twenty-, fifteen- or ten-year mortgage. As an investor, you should seek longer-term savings deposits or bonds.

24. RISK PREMIUM

In economics and finance, the “risk premium” is the expected additional return on an investment to compensate for the risk of that type of investment. It is the difference between the actual return rate and a “risk-free” return rate often represented by Treasury securities or some other risk-free standard.

In finance, the risk premium can be the expected rate of return above the risk-free interest rate. When measuring risk, a common-sense approach is to compare the risk-free return on T-bills and the very risky return on other investments. The difference between these two returns can be interpreted as a measure of the excess return on the average risky asset. This excess return is known as the risk premium.

What You Should Know

The explanation of risk premiums can get fairly technical, so the best way to describe them is by example. Suppose you’re considering buying a ten-year corporate bond that pays 4 percent. If a ten-year Treasury bond is currently paying 2 percent (see #23 Yield Curve), then you would be receiving a additional 2 percent to cover the risk of the company’s credit quality, or default. Similarly, if you buy a stock expecting a 5 percent or greater return on it, the difference between that return and 2 percent would be your expectation to compensate you for the risk.

Part of the reason the normal yield curve (see #23 Yield Curve) slopes upward as maturity lengthens is to cover the additional risk inherent in longer maturities. That risk can come from default risk, interest rate risk (the risk that interest rates might rise over the holding period), and inflation risk. All three of these types of risk are built into a risk premium. The risk premium also takes into account any collateral pledged on the loan and the “seniority”—that is, the order in which any debt would be paid in a bankruptcy or liquidation.

Why You Should Care

Unless you’re employed in the world of high finance, you probably won’t encounter the term “risk premium” very often in your work, or even in your investing. It’s best to think about it conceptually. When you make an investment, you should ask yourself: “Does the expected return on this investment compensate me for the risk I’m taking?” If it does, the risk premium is in line with reality, and the investment may make sense. If the risk premium is insufficient—that is, the payoff doesn’t compensate you for the risk compared to a risk-free return—look elsewhere.

25. BOND PRICES VERSUS INTEREST RATES

“Bonds were up today. The ten-year Treasury was up 23/32 in active trading.”

You hear it on the news. But what does it mean when bond prices go up? Is that a good thing, like hearing about stock prices going up?

The answer is—it depends. Yes, the above news item is usually good news. It’s obviously good news if you already own bonds—your bonds went up in value. But it’s also good news if you’re planning to borrow money, because it means market interest rates are lower.

What You Should Know

When a bond price goes up, that means market interest rates have moved lower. Why? Because bonds are sold originally with a fixed coupon, or interest payment. A bond issued and sold at a typical $1,000 face value that yields 4 percent will pay exactly $40 per year in interest, period. It may pay that interest once a year, or in two semiannual payments of $20—that doesn’t really matter.

Even though most bonds are issued in $1,000 increments, they’re quoted as if they sell for $100, a figure known as par. If that bond rises 23/32 (of a dollar), that’s the equivalent of saying the bond price rose 71.9 cents to $100.72. Returning to the $1,000 face-value scenario, if you take the $40 in interest and divide it by $1007.20, you’ll get an implied interest rate of 3.97 percent, down from the 4 percent it was originally sold for.

Here’s the “it depends” part of bond prices and interest rates. Normally, the rise in bond prices and the corresponding fall in interest rates are a good thing. But first, that’s only true if you’re a borrower—if you’re a saver, you prefer higher interest rates. Second, the rise in bond prices can often occur as a “flight to quality”—when other assets such as stocks are perceived as more risky, and investors flock to bonds. This may push interest rates down, but only at the expense of other economic pain.

Why You Should Care

So if you hear that bond prices rose, that means interest rates—rates you would receive or rates you would pay, say, on a mortgage or car loan—are going down. Conversely, if bond prices fall, that means that interest rates are going up. Especially if you’re in the market for a mortgage, you want to watch the ups and downs of the bond market closely.