For the first time in over a decade, the U.S. 5 year bond yield fell below that of a 2-year bond. Alarm bells start ringing when the 10-year bond falls below the 2 or 1-year bond, so market watchers are keeping their eyes out for further movement.
You may have never heard of an inverted yield curve before this month--or even before this blog if you don’t regularly follow financial news--but it’s something all of us with investments should understand as it could have an impact on our portfolios. We turn to personal finance experts from Boomer & Echo, My Own Advisor, Cut the Crap Investing and Tawcan, plus CoPower’s own Jennifer Macdonald to help simplify the concept and explain what investors need to know.
What is an inverted yield curve?
As Jennifer Macdonald explains, “The first thing to understand is what a normal yield curve looks like.” As you can see in the chart below, longer-term bonds, like 10 or 30-year bonds will have higher yields than shorter-term bonds like a 2 or 5-year bond. “Normal yield curves are upward sloping because investors expect to get a higher yield, or return, for lending capital for 10 years, for example, rather than 2 years, as there’s an increased risk associated with the longer term.”
An inverted yield curve is where the long end of the curve moves downward and yields on longer-term bonds slip below the shorter-term ones.
This month, the yield on the US Treasury’s 5-year bond dipped below the 2-year bond for the first time in more than a decade. “It’s a signal that all is not well in the bond market,” said Jennifer. “Investors have been increasingly looking for yield in this environment. That means there’s greater demand for longer-term bonds which pushes their prices up and their yields down.” (Editor’s note: To learn more about the inverse relationship between a bond’s price and its yield check out our blog on Bank of Canada bond rates.)
Why is this a big deal?
As Robb Engen of Boomer & Echo notes, “an inverted yield curve is said to signal the beginning of a recession and a stock market correction.” This is what the headlines are all about.
In fact, as Bob Lai of Tawcan reminds us, “an inverted yield curve has predicted every recession since 1955. It’s an abnormal situation and a big deal because essentially investors are saying that the economy will be better in the long-term than in the short-term.”
But not everyone is convinced. “Nobody can predict the financial future with any accuracy. Heck, nobody can even get the weather right one day in advance!” said Mark Seed of My Own Advisor--a sentiment reflected by others as well. Rick Newman on Yahoo Finance notes that “inverted yield curve can be a false alarm...The difference between 10-year and 1-year Treasury rates went negative in 1966, but no recession ensued.”
So what should investors do, and should they do anything at all?
The question of whether or not this month’s inversion signals a pending recession is making all the headlines this month, but according to Robb Engen, a recession if it happens, could still be a ways away. “A correction has occurred anywhere between 2 and 23 months after the start of the yield curve inversion, making it difficult for investors to time their strategy,” he said.
“For equity investors, the theory is defensive stocks tend to be better investments because those companies are less affected by any major changes in the economy or pending recession,” said Mark Seed. What types of defensive stocks? “Think utilities, healthcare stocks, consumer companies and residential real estate investment companies.” (Editor’s note: to learn more about defensive investing check out our blog on using clean energy and energy efficiency infrastructure to diversify your portfolio.)
Bob Lai agrees with the strategy of diversification. “One recommendation that the average investor may want to consider is to diversify their investments. Rather than just invest in equities like individual stocks, index ETFs and publicly traded bonds, the average investor may want to also look into private investments like CoPower Green Bonds.”
“Those close to or in retirement may want to rethink their asset allocation and shift to safer investments with the portion of their portfolio that they'll need to access in the immediate future for retirement income,” said Robb. “But investors with a long time horizon should probably ignore any speculation around economic trends and just stick with their regular contributions and asset allocation,” he continued. At age 39, Robb is prepared to ride out any short-term market volatility to potentially earn higher returns in the long-term.
Investing for the long-term and sticking to your financial game plan is advice all the experts we consulted agree on.
“I think most investors should think, act and behave long-term. That means, your investment plan should be looking at your needs years if not decades into the future,” said Mark who also isn’t considering any changes to his portfolio.
Dale Roberts from Cut the Crap Investing believes investors need to be prepared for a stock market correction at any time and invest accordingly. “We should always invest within our risk tolerance level. We never know where we are in any 'investment cycle', we do not know how close we might be to the next recession or stock market correction.”
While Dale doesn’t consider the yield curve inversion a reason in itself to make changes, it does provide a nice reminder that markets can correct and the value of your stocks could be cut in half. A good exercise according to Dale is to ask yourself “how you’d feel if your portfolio went down by a significant percentage? What is your comfort level for risk? Match your portfolio to your comfort level and add the appropriate investment grade bond allocation to reduce risks.”
“We don't know when the correction will come, and the correction might not be large enough to create an investment opportunity. Market timing does not work. Investing on a regular schedule and keeping fees low does.”
For an investor with the right investment objectives and an appropriate risk tolerance, CoPower Green Bonds could be worth considering as investors contemplate the implications of an inverted yield curve. But as always, no investment is perfect for all investors at all times, so we encourage each investor to do their research and consult with a financial professional.