What Does an Inverted Yield Curve Mean for Retirement Investors
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The current yield on a one-year U.S. Treasury bond is 4%, but the yield on a 10-year Treasury bond is only 3.5%. Why is this? What does it mean for retirement savers, and how should investors respond? That's what I'm tackling today on the show. To grab the links and resources mentioned, just head over to youstaywealthy.com forward slash 168.

The risk-free rate is the rate of return offered by an investment that theoretically carries zero risk. I say theoretically because in practice, the risk-free rate of return doesn't truly exist since every investment out there carries at least some form of risk, even if it's not in the traditional sense.

But for U.S. investors, the yield on a short-term U.S. Treasury bond is often used as the risk-free rate. And that's because an investment in a U.S. Treasury bill or U.S. Treasury bond is backed by the full faith and credit of the United States and therefore is deemed one of the safest investments that one can make.

For today's episode, we're going to use the yield on a one-year U.S. Treasury bond as a reflection of the current risk-free rate. And as stated at the top of the show, the current yield on a one-year U.S. Treasury bond, i.e. the risk-free rate, is 4%. This means that if you invest $100,000 into a one-year U.S. Treasury bond today, you'll have earned $4,000 of interest when that bond matures in 12 months without taking really any investment risk.

On the other hand, if you invest $100,000 into a 10-year U.S. Treasury bond, you'll only be earning $3,500 every 12 months in interest for the next decade. And that's because a 10-year U.S. Treasury bond is currently yielding 3.5%, half of a percent less than the one-year bond. So why would anyone buy a 10-year bond if they can earn a higher interest rate on a one-year bond with the same exact credit quality?

Before we answer that, let's quickly address why this is happening in the first place. Because as you might already be thinking, longer term bonds usually offer a higher yield than shorter term bonds. Not all that different than a CD that you would buy at a bank. You would expect to be paid a higher interest rate on a five-year CD than a one-year CD.

You're locking your money up for a longer period of time, one form of risk, and therefore you would expect to earn a higher rate of return. More risk, more return. Now, circling back to bonds, when shorter-term bonds carry a higher yield than longer-term bonds, we call this a yield curve inversion.

I've discussed this one other time on the show, and I'll link to it in the show notes. But this time around, the yield curve is experiencing its steepest inversion in over 20 years. Now, an inverted yield curve doesn't guarantee a recession. However, it is a closely watched indicator of a potential recession in the near to medium term.

An inverted yield curve is really indicating that investors or some investors expect trouble to be around the corner. That potential trouble, i.e. a recession, often leads to lower interest rates on longer term bonds. So those investors who are predicting trouble, they want to load up on long term bonds right now before the rates decline. And this race to buy longer term bonds pushes the yield lower, lower than short term bonds, at least temporarily.

The opposite is also true. When investors expect a period of rapid growth, longer-term bonds and bonds in general will have lower interest rates. Lower interest rates are used to encourage spending and investments in the riskier equity markets, both of which can be contributors to economic growth.

Now, even though an inverted yield curve doesn't necessarily guarantee that a recession is around the corner, economic officials do often pay close attention to bonds and interest rates, and they can be influenced to take action when the curve inverts in an effort to try and avoid a catastrophic event.

As noted in recent episodes here, the Fed has put themselves in a pretty tough position at the moment, and time will tell if the policy response to the current economic conditions will prevent a recession or at least mitigate its severity.

Until then, investors like you and me, we still have decisions to make with our money. And with the one-year U.S. Treasury yielding more than the 10-year, many investors might be wondering what the catch is. Why would anyone buy a 10-year bond? Shouldn't they just put their entire bond allocation in one-year treasuries since they're yielding more?

To help arrive at an answer to these very good and logical questions, we have to recognize that although U.S. Treasury bonds don't contain investment or credit risk, they aren't 100% risk-free. For example, if I buy a 10-year U.S. Treasury bond yielding 3.5%, I know the exact outcome of my investment every year for the next 10 years, and I can build a plan around that.

That certainty can be valuable for a certain investor with a certain set of goals.

On the other hand, if I buy a one-year U.S. Treasury bond to capture the slightly higher yield of 4%, well, it's anyone's guess what my options are going to be when I go to reinvest my proceeds in 12 months. What if a one-year Treasury in 12 months is only yielding 2% at that time? Well, that previous 3.5% yield on a 10-year bond is now looking pretty attractive to me. In fact...

If that were to happen, I may now be tempted to buy a longer term bond next time around with my proceeds. Let's say I buy a five year bond with my proceeds because I don't want to get stuck again in 12 months. But shortly after buying interest rates spike and now my five year bond isn't looking like such a great choice. You can see how this this one short term decision can spiral into a series of emotional, challenging and sometimes costly decisions in the future.

My guiding philosophy in life and in investing is to focus on the things we can control. We

We can't control where interest rates will be in the future, and it's impossible for us to know if buying a one-year bond today is better than buying a 10-year bond, which is why I prefer to own and hold thousands of bonds with different maturities over long periods of time, helping to reduce interest rate risk and maybe more importantly, reduce the odds of me getting in the way and becoming my own worst enemy trying to outsmart the markets.

Over a long period of time is a key word there because in retirement, creating an income stream from our investments for the next 30 to 40 years is a long period of time. And trying to time the bond market and obsess over how to take advantage of an inverted yield curve and determine what maturity bond to buy next, these things rarely match up with the goal of creating a consistent, reliable retirement paycheck for the next 30 plus years while also ensuring we don't run out of money.

There are, in my opinion, far more important decisions to be making than how can I take advantage of an inverted yield curve over the next six to 12 months, especially when you can invest in thousands of high-grade bonds through an ETF or a mutual fund at virtually no cost.

Yes, it's not fun to see the principal value of your bond fund decline here in the short term. But again, we aren't investing for the short term, or at least we shouldn't be. Most retirement savers and retirees aren't investing for the next 12 months or even 10 years. A 65-year-old entering retirement today is investing for the next 30 years. And just like stocks, we can't let short-term events cause us to react and make emotional changes that can have negative long-term impacts.

I've previously dispelled the myth that rising rates equals a negative return on bonds. And if you want to listen to that episode again, I'll link to it in the show notes. It might also be a good time to revisit my nerdy four-part series on investing in bonds. I'll link to that in the show notes as well, which can again be found by going to youstaywealthy.com forward slash 168. Okay. Two final things I want to touch on before we part ways today. First, I

I want to point out what the current state of the bond market, and specifically the risk-free rate, means for your overall investment plan going forward. The risk-free rate, the 4% that you can earn on a one-year treasury bond right now today, should be your current starting point for any investment that you're considering. In other words, if

If you're going to take any risk with your investments, you're going to expect something more than 4%. This means that riskier asset classes like stocks should have a higher future expected rate of return today than they did yesterday or a few months ago. Otherwise, nobody would invest in them. Nobody would invest in riskier asset classes if they didn't expect a return that properly compensates them for the risk they're taking above and beyond US treasuries. So

Keep this in mind as you evaluate your asset allocation and financial plan and look to make any necessary investment changes going forward. Just take note of how quickly interest rates can move. The one-year treasury is yielding about 4% today, and that might be your starting point today, but that can change tomorrow or next month. So don't latch onto this 4% number that we've discussed today. Second,

While the uptick in short-term interest rates may not change your long-term asset allocation decisions, it may present an opportunity to improve your cash management strategy. To put this opportunity into perspective, the one-year U.S. Treasury was yielding about 0.4%. Yes, that same one-year U.S. Treasury was yielding about 0.4% at the end of 2021, so eight months ago. At the same time, that annual headline inflation rate was around 7%.

Today, that risk-free rate, that one-year U.S. Treasury bond is in that 3% to 4% range. Today, it's 4%. And annualized headline inflation sits around 8%. So if your cash is managed appropriately, you're able to better protect your purchasing power today given higher interest rates than eight months ago.

Unfortunately, it takes some extra effort to do so because the big banks that we all know by name, they are not passing these higher interest rates off to their customer. So you'll either need to leverage an online bank like Ally or Capital One or consider buying individual U.S. treasuries as a cash alternative.

Just remember that unlike an FDIC money market account provided by an online bank, U.S. treasuries do fluctuate in value day to day. So if you buy a one-year U.S. treasury as a money market alternative today, you'll want to commit to holding it until maturity. You'll want to commit to holding it for that entire 12 months.

Okay, that's a wrap for today. Once again, to grab the links and resources mentioned, just head over to youstaywealthy.com forward slash 168. Thank you as always for listening, and I'll see you back here next week. This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.