Short-term bonds, CDs best bet during curve

You may have seen that the yield curve inverted recently, as short-term interest rates became higher than long-term ones for the first time in five years. What’s that mean to us?

Traditionally, it’s a sign we should all get ready to tighten our belts, as the lower long-term rates signal a coming recession. This time it’s not so clear the economy really is poised to slow down.

But the inverted yield curve does dictate changes in some savings and investing strategies. And it makes one curious: Why do so many investors continue buying long-term bonds when short-term ones pay more and carry less risk?

The yield curve is a line showing interest rates on a graph, with short-term rates on the left and long-term ones on the right. Typically, long-term rates are higher – to pay investors for tying their money up longer.

An inverted yield curve happens when short-term rates are higher. This occurred Dec. 27 when the two-year U.S. Treasury note yielded 4.347 percent and the 10-year Treasury 4.343 percent. A year ago, the yields were about 3 percent and 4.3 percent, respectively.

Short-term rates are heavily influenced by the Federal Reserve, which has driven rates up 13 times since June 2004 to head off inflation. Long-term rates are set by supply and demand as bonds are traded in the secondary market – and these traders apparently don’t share the Fed’s inflation fears.

Although low long-term yields traditionally forecast recession, surveys show most economists expect a strong economy this year. So other factors may be at play. Foreigners’ high demand for Treasuries helps keep long-term yields low, for example.

But why would anyone tie money up in a 10-year bond when a two-year pays as much?

Because current yield isn’t the only thing investors consider. For many, the primary goal is the safety offered by Treasuries, which are guaranteed by the U.S. government.

Some investors also figure the relatively high short-term yields are temporary, so they prefer to lock in a good yield with a long-term bond.

And some are betting that if yields on long-term bonds fall, high demand will drive up prices on the more generous ones that can be bought today. Price increases from falling interest rates are more pronounced with long-term bonds because the benefits last longer.

But betting on bond price changes is for pros. Small investors should plan to hold bonds until they mature – when the bond issuer pays the investor the bond’s face value.

So, with the yield curve inverted, small investors should stick with short-term bonds and bond funds.

I’d still emphasize stocks for my long-term retirement accounts. But stashing more cash in short-term bonds and CDs would be a good way to reduce your overall risk without feeling you’re cheating yourself.