How Come Longer Term Bonds Yield Less Than Short Term Bonds?

In the investment world, the argument has always been that if you are willing to commit your money to an investment for a longer period of time, you will be rewarded with a premium. That has been the case with several types of bonds as well as longer-term bonds can mean more risk.

A longer-term commitment has also generally meant more yield. Yet, recently, we have seen higher yields on shorter-term bonds compared with longer-term bonds. When this occurs, it is called an inverted yield curve.

The phenomenon is often a reflection of investor sentiment around the state of the economy. It can also be a precursor to recession. The unusual set of circumstances can often point to a downturn in business activity and revenues.

Unfortunately, an inverted yield curve has accurately predicted the last ten recessions.

To understand the inverted yield curve, it is most instructive to consider government debt instruments. When an investor purchases Treasury securities, they are helping fund the federal government. In return for this loan to the government, the investor is paid interest as reward for their loan.

While the interest rate, or the coupon rate, on a Treasury bond does not fluctuate, the yield does because the value of Treasurys fluctuates in the secondary market. The yield-to-maturity is the total return the bondholder receives from the coupon and principal repayment.

There is an inverse relationship between bond prices and interest rates. If the bond price decreases, the yield-to-maturity increases.

Government Debt Instruments

Government debt instruments are broken into three categories based on maturity. There are Treasury Bills (T-Bills) with maturities of one-year or less. There are Treasury Notes (T-Note) with maturities that can range from two to 10 years and Treasury Bonds (T-Bond)
maturing in 10 to 30 years.

There are also Savings Bonds, I-Bonds and Zero-coupon bonds.

Although it is easier to think of risk when discussing stocks, especially in times of volatility, bonds also have both interest rate risk and inflation risk.

The yield curve can apply to municipal bonds and corporate bonds as well. Municipal bonds are issued by cities and towns to fund local projects.

If professional investors have concerns about the future of the economy or stymied economic growth, short-term yields will rise as investors look to invest in longer-term bonds. This also happens when the Federal Reserve is raising interest rates because the federal funds rate, the Fed’s target rate, has an impact on shorter term bonds.

This is concerning because the accuracy of the indicator to accurately predict recessions cannot be overlooked. As of November 21, 2022, the yield on a two-year bond was 4.24 percent while the yield on a ten-year bond was 3.93 percent. The yield curve was already inverted in August.

In the meantime, the Fed will continue more monetary tightening.