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David Blanchett and Michael Finke

Portfolio > Economy & Markets > Fixed Income

T-Bills vs. Treasury Bonds: Which Should You Pick When the Yield Curve Inverts?

By David Blanchett By Michael Finke

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What You Need to Know

  • The current Treasury yield curve is deeply inverted.
  • This forces investors to choose between earning a higher rate for a year or locking in the highest 10-year rates since 2007.
  • Historically, pivoting to bills when yield curves are inverted has paid off, but only if investors move back into bonds when the yield curve normalizes.

The current Treasury yield curve is deeply inverted, offering 5.4% for one-year T-bills and just 4.3% for 10-year Treasury bonds.

Investors are caught between the temptation to earn a higher rate for a year and then hope for the best next year, or lock in 10-year rates that are the highest they’ve been since 2007. That same 2007 investor would have done well focusing on long-term bonds, but the yield curve has been inverted for over a year now, rewarding investors who invested in short-term Treasurys.

An investor has two choices. Buy a 1-year Treasury Bill and earn 5.4% for the next 12 months and then reinvest, or buy long-term Treasury bonds today. Where will interest rates on long-term bonds be a year from now? Are interest rates predictable when the yield curve inverts?

Since inverted yield curves are relatively rare, we can look at the historical evidence from multiple countries to get a sample size large enough to form a conclusion. We find that pivoting to bills when yield curves are inverted has been the smart decision historically, but only if investors keep an eye on their bond portfolio and move back into bonds when the yield curve normalizes.

Future changes in bond yields seem to be random when the curve is inverted, meaning that the 10-year rates a year from today are no more likely to be higher than lower than they are today. However, there is definitely a downward longer-term trend in bills that will likely result in investors in bills experiencing lower returns than bonds.

Investing for the Long Term

Investors generally expect to be rewarded for holding bonds that mature in the more distant future instead of short-term cash. It may seem that the opportunity cost of cash goes away when yields on money markets are higher than 10-year Treasury bonds.

However, rates on 10-year Treasurys never cracked 2% in 2020 and 2021, and an investor can lock in a decade-long yield above 4% today. The so-called expectations hypothesis would suggest that the market believes rates will fall within the next few years, which could punish investors who were tempted into move bonds into cash today.

In other words, investors can get 5.4% if they buy a one-year T-bill. If they invest in a two-year Treasury with a 4.7% yield, the second-year yield expectation is just 4.3% (5.4% the first year and 4.3% the second year).

Between year 2 and year 10, the market expects an annual yield of just 3.8%. So an investor who buys a 10-year bond instead of a short-term Treasury is betting that rates will drop by over 1.5% after the next year or two. Is this a good bet?

The bet is really about whether long-term investors should grab attractive Treasury bill yields today and then reinvest in one year. If the inverted yield curve contains accurate information about future yields, then there will be no advantage to investing in cash.

We can answer this question by looking at historical bond performance data in different yield curve environments using returns from 16 developed countries between 1870 and 2020 using the Jordà-Schularick-Taylor (JST) Macrohistory Database.

The JST dataset includes data on 48 real and nominal returns for 18 countries from 1870 to 2020. Economic data for Ireland and Canada are not available, which is why only 16 countries are included in the analysis.

Bill yields exceed bond yields in only 24% of the historical periods. An inverted yield curve is more common in some countries, such as the United States, than others, such as France. We bin countries individually versus across years so that each country has the same weight.

What is the difference in the future one-year return on bonds and bills in different yield environments?

The exhibit below includes the average annual values in Panel A and the probability of bills outperforming bonds in Panel B.

Difference in Future Returns by Yield Environment

Panel A: Bill Yield Minus Future 1 Year Bond Return     Panel B: Probability of Higher Bill Return

Bond Yield minus Bill Yield (%) Bond Yield minus Bill Yield (%)
<0 0-1 1-2 >=2 Avg <0 0-1 1-2 >=2 Avg
AUS -1.30 -0.13 -1.59 -1.51 -1.13 AUS 43 57 37 46 46
BEL 0.46 -1.58 -2.69 -3.93 -1.94 BEL 53 45 32 25 39
CHE 0.79 -1.32 -2.13 -3.01 -1.42 CHE 60 29 38 26 38
DEU 1.19 -0.81 -1.83 -4.72 -1.55 DEU 62 37 31 22 38
DNK 0.07 1.28 -6.46 -1.35 -1.61 DNK 61 52 44 43 50
ESP 0.61 -1.26 -2.60 -2.79 -1.51 ESP 50 33 16 36 34
FIN 1.72 -1.74 -5.95 -5.35 -2.83 FIN 64 33 14 29 35
FRA 1.72 -0.85 -3.41 -2.59 -1.28 FRA 58 49 26 41 44
GBR 2.04 -1.59 -1.85 -3.61 -1.25 GBR 71 40 33 42 47
ITA 2.41 -2.03 -2.31 -3.56 -1.37 ITA 68 44 34 31 44
JPN -0.03 -2.91 -1.94 -2.75 -1.91 JPN 59 31 17 21 32
NLD -0.20 -0.08 -2.23 -3.88 -1.60 NLD 55 49 22 35 40
NOR -0.02 -1.57 -1.24 -2.31 -1.28 NOR 58 33 30 21 35
PRT -0.66 -0.50 -2.38 -5.70 -2.31 PRT 34 39 44 27 36
SWE 0.97 -0.84 -3.71 -5.35 -2.23 SWE 68 44 23 35 43
USA 0.94 -1.73 -0.32 -4.68 -1.45 USA 57 54 48 29 47
Avg 0.67 -1.10 -2.67 -3.57   Avg 58 42 31 32  

Source: Authors’ Calculations, JST Macrohistory Database, Data as of Dec. 31, 2020

The <0 column indicates an investment made when the yield curve inverts. There seems to be a consistent relationship between yield spreads and subsequent one-year returns. When cash has a higher yield than longer-term bonds, the average one-year return is 67 basis points (0.67%) higher for cash.

The term premium reappears during periods where bond yields exceed cash yields, and the return difference rises with the yield spread. In environments when bill yields exceed bond yields, the future return on bills tends to be positive 58% of the time. In other words, when bill yields are higher than bond yields, bills tend to outperform bonds.

Not only is the return higher, but the risk of investing in bills is lower. If we assume the bills have a one-year term and are held to maturity, there is no price risk.

In contrast, a bond portfolio purchased through an ETF or mutual fund would fluctuate in value depending on future changes in yields. This effect was especially pronounced in 2022 when many bond funds had returns in the neighborhood of -15% due to the rise in yields.

A reason to avoid buying short-term bills when bill yields exceed bonds yields is that that bond yields will subsequently decline, resulting in reinvestment risk of the one-year bill investment. An investor who locked in a 5% one-year bill, only to see yields fall over the next 12 months to 3% would have missed out on the opportunity to lock in a higher long-term rate.

To see what happens in the future in various environments, we compare the future yield on bonds (Panel A) and bills (Panel B) three years later based on the current/initial bond minus bill environment.

Future Changes in Yields

Panel A: Change in Bond Yields + 3 Years                            Panel B: Change in Bill Yields +3 Years

Bond Yld minus Bill Yld (%) Bond Yld minus Bill Yld (%)
<0 0-1 1-2 >=2 Avg <0 0-1 1-2 >=2 Avg
AUS -0.27 0.40 -0.07 -0.78 -0.18 AUS -0.99 0.10 0.30 0.94 0.09
BEL 0.03 -0.40 0.22 -0.02 -0.04 BEL -0.72 -0.76 0.94 0.30 -0.06
CHE -0.06 0.12 -0.53 -0.12 -0.15 CHE -0.65 -0.17 -0.17 1.14 0.04
DEU -0.17 -0.13 -0.10 -0.16 -0.14 DEU -2.10 -0.26 0.14 0.94 -0.32
DNK 0.07 0.03 -0.70 -0.47 -0.27 DNK -0.46 0.21 -0.22 0.75 0.07
ESP 0.67 0.25 -0.20 -1.40 -0.17 ESP -0.19 0.11 -0.05 -0.25 -0.10
FIN 0.44 0.11 -0.37 -0.95 -0.19 FIN -0.65 -0.24 -0.25 0.31 -0.21
FRA -0.07 -0.27 0.03 -0.18 -0.12 FRA -1.94 -0.83 0.30 0.75 -0.43
GBR -0.12 0.01 0.05 -0.11 -0.04 GBR -1.56 0.11 0.79 0.71 0.01
ITA 0.57 -0.49 0.02 -0.32 -0.05 ITA -0.77 -0.72 0.27 0.70 -0.13
JPN -0.32 0.16 -0.06 -0.47 -0.17 JPN -1.72 0.12 0.24 0.82 -0.13
NLD -0.17 -0.04 0.02 -0.40 -0.15 NLD -1.99 -0.29 0.47 0.86 -0.24
NOR -0.04 -0.20 -0.28 0.28 -0.06 NOR -0.63 -0.15 -0.29 0.67 -0.10
PRT 0.83 0.08 -0.17 -1.34 -0.15 PRT -1.00 -0.52 0.22 0.95 -0.09
SWE 0.13 0.11 -0.20 -1.07 -0.26 SWE -0.21 0.05 -0.02 -0.45 -0.16
USA -0.13 0.04 0.23 -0.62 -0.12 USA -0.78 -0.07 0.76 0.91 0.21
Avg 0.09 -0.01 -0.13 -0.51   Avg -1.02 -0.21 0.22 0.63  

Source: Authors’ Calculations, JST Macrohistory Database, Data as of Dec. 31, 2020

When an investor buys a bill during an inverted yield curve environment, over the next three years there is no indication that bond yields end up falling as would have been predicted according to the expectation hypothesis. On average, an investor doesn’t lose out on an opportunity to lock in attractive long-term bond rates when they take advantage of high short-term bill yields.

While the future yields on bonds appears to be relatively random, future bill yields tend to decline when bill yields exceed bonds and vice versa. In other words, the shape of the yield curve tends to normalize, where bond yields exceed bill yields, but the overall level of the curve is relatively random.

This suggests an inverted yield curve is relatively temporary environment. Investors aren’t punished for shifting from long-term bonds to short-term bills during periods when markets are providing a bonus to reduce duration.

Implications for Today’s Environment

While Treasury bill returns are predictable with little risk, longer-term bond returns are unpredictable and volatile.

An investor can lock in today’s high yields on short-term bond investments with no tradeoff in terms of expected long-term bond returns, and can achieve significantly lower short-run volatility from their bond portfolio.

Therefore, investors looking for a low-risk return today should potentially consider allocating to shorter duration fixed income investments, but need to be ready to pivot back into longer duration bonds when the yield curve normalizes.

David Blanchett, Ph.D., CFA, CFP, is managing director and head of retirement research for PGIM DC Solutions, the global investment management business of Prudential Financial Inc. Previously, he worked at Morningstar Investment Management LLC and Unified Trust Co.

Michael Finke is a professor and Frank M. Engle Chair of Economic Security at the American College of Financial Services and leads the Wealth Management Certified Professional designation program.

(Image of David Blanchett, left, and Michael Finke)

David Blanchett

Michael Finke

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