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Portfolio > Mutual Funds > Bond Funds

How to Invest With an Inverted Yield Curve

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With so much attention being paid to the inverted yield curve and the recession that’s likely to follow six to 24 months later, financial advisors may be overlooking a key opportunity for their clients’ cash and fixed income assets: locking in current interest rates.

One-year CDs are paying as much as 2.75% to 2.85% with minimums of $1,000 or less and those rates may not last, according to DepositAccounts.com, a website that tracks bank deposit rates. It reports that several “rate leaders,” especially credit unions, have cut CD rates in the past few weeks.

(Related: Gary Shilling: A Recession Is Coming, and Maybe a Bear Market, Too)

CDs from thrifts and banks will tend to pay more than CDs sold through the brokerage channel unless the latter are bought in the primary market, not the secondary market, which involves commissions.

“CDs are paying very well, with very little default risk — and none if they’re under FDIC limits,” says Leon LaBrecque, chief growth officer at Sequoia Financial Group. But they aren’t liquid and early redemptions come with penalties.

“I’m anticipating flat to lower rates in the next 12-18 months [and] recommending to clients that they lock in CD rates now and go further out on the yield curve,” says Eric Walters, founder and president of Silvercrest Wealth Planning, based in the Denver area.

Given the Federal Reserve’s latest projections for growth and inflation, Walters expects U.S. bond yields will be stable for the next one to three years unless growth is unusually strong or inflation rises sharply.

At the conclusion of its March 19-20 Federal Open Market Committee meeting, the Fed lowered its outlook for growth and headline inflation this year and next. By the end of that week, the yield curve inverted for the first time since 2007, with the 3-month Treasury bill trading at a slightly higher yield than the 10-year Treasury note.

In late trading Tuesday, the 3-month and 6-month T-bills were yielding more than the 2-year, 5-year and 10-year Treasury note. The 3-month T-bill was yielding 2.45% compared with 2.42% for the 10-year note and 2.27% and 2.20% for the 5- and 2-year notes, respectively. Only the 30-year Treasury bond yield, at 2.87%, topped the T-bill yields.

“Cash is much more appealing than bonds now and you don’t have to put up with price volatility,” says Greg McBride, chief financial analyst at Bankrate.com.

But bonds still have their place in client portfolios along with money market funds, which are more liquid than bonds or CDs.

Kevin Galvin, director of research at Hopwood Financial Services in Reston, Virginia, uses the Schwab government money market fund, which is yielding over 2%, as well as bonds and CDs to match client cash flows to liabilities. “Safety first, income second,” says Galvin.

Like many other financial advisors, Galvin uses bond ladders, investing in bonds of different maturities to diversify holdings, protect against rising rates — proceeds of short-term bonds can be reinvested at higher rates — and to match cash flows to clients’ needs.

Given the current yield curve and economic outlook, he’s not going out on the curve beyond seven years — he previously would go out as far as 10 years — or buying corporate bonds with a credit rating less than A.

Tim Baker, founder and CEO of Metric Financial in Granby, Connecticut, who usually uses bond ladders, says there’s currently “not much value in moving past the two-year. The only way to pick up yield is to buy a 30-year Treasury, which is a pretty big call with rates as low as they are,” says Baker. “The one area that offers some improvement for fixed income investors is corporate bonds.”

A generic 10-year Baa-rated corporate bond was yielding 2.28% more than a 10-year Treasury as of Monday, compared with 1.78% at the beginning of the year. Investors looking to pick up some yield after the Fed’s move could buy corporates, but first they “should consider their appetite for credit risk,” says Baker.

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