The yield curve has returned to “normal” status, whereby long-term interest rates exceed short-term rates. The chart below depicts the spread between the 10-year Treasury note and the 13-week Treasury bill. In mid-May the spread became positive. Long term rates, however, remain well below their historical average. The second chart displays the yield on the 30-year Treasury bond since 1977.
The reason for holding fixed-income securities is to provide portfolio stability. Empirical evidence suggests that if bonds are used prudently, an investor can significantly reduce the “swings” in portfolio value that are driven by the volatility inherent in our other recommended asset classes, chiefly common stocks. The key, of course is prudent use; we have never recommended that investors hold bonds with maturities that exceed five years. Bonds with longer maturities have, historically, been much more volatile while providing little additional return.
Nominal interest rates on conventional bonds include a real return component plus a “premium” that investors demand for assuming the risk of price inflation. After all, a purchaser of traditional bond is paying for a future stream of income that is fixed, plus the bond’s face value upon maturity. The purchasing power of both is diminished over time by rising prices for goods and services.
It is possible to estimate this “premium” and thereby gauge the market’s expectations regarding price inflation. The yield-to-maturity on conventional Treasury securities includes both a real rate of return plus this inflation premium. Treasury inflation indexed securities of similar maturities, on the other hand, do not; they reflect only a real interest rate since their coupon payments and redemption values are indexed to the CPI. The difference in these yields is therefore the market’s assessment of expected annual price inflation. The market is currently anticipating that price inflation will range between 2.3 percent and 2.5 percent annually over the next 5-20 years.
It may seem surprising that the market is forecasting such mild inflation; after all annual price inflation as measured by the CPI has averaged over four percent since the end of World War II. We will not, however, second-guess the market. We remain confident that our recommended portfolios will provide adequate protection against rising prices. This requires that investors assume the risk of holding highly volatile asset classes including gold and common stocks. But, to repeat, cash and short-term bonds have proven to be effective at offsetting these fluctuations.
Also In This Issue
Quarterly Review Of Investment Policy
Focus On: Private Equity – What’s The Deal?
The High-Yield Dow Investment Strategy
The Dow Jones Industrials Ranked By Yield
Recent Market Statistics
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