Re:The U.S. Yield Curve Has Inverted
by JumpCrisscross on Monday December 03, 2018 @05:07PM
(#18593610)
> A 5-year bond now has a lower yield than a 3-year bond? How is that even possible? Wouldn't anyone who wants a 5-year bond just buy a 3-year bond and then put the cash under their mattress after 3 years?
Today's rates show the 3-year yielding 284bps and the 5-year yielding 283bps (the same as the 2-year) [1]. Let's consider three hypothetical buyers' outcomes. To keep things simple, we'll assume interest isn't re-invested.
One buys the 5-year. $10,000 of their principal would turn out $1,415 in interest [2]. Another buys the 3-year, keeping the principal as cash on redemption. $10,000 of their principal turns into $852 in interest [3]. Immediately, you see why the 5-year is a better buy for a 5-year investment horizon than the 3-year.
Consider a third buyer. They buy the 3-year with the aim of re-investing. To get the $563 difference between the 5-year and 3-year total interest pay-outs, they would need to buy a 2-year bond yielding 282bps when the 3-year matures [4]. If rates are lower 3 years' hence, the 5-year investor will have done better. If rates are higher, the 3-year buyer with intent on reinvesting will have done better.
This reinvestment risk, which incorporates the market's views on future interest rates, is what the yield curve essentially reflects.
Today's rates show the 3-year yielding 284bps and the 5-year yielding 283bps (the same as the 2-year) [1]. Let's consider three hypothetical buyers' outcomes. To keep things simple, we'll assume interest isn't re-invested.
One buys the 5-year. $10,000 of their principal would turn out $1,415 in interest [2]. Another buys the 3-year, keeping the principal as cash on redemption. $10,000 of their principal turns into $852 in interest [3]. Immediately, you see why the 5-year is a better buy for a 5-year investment horizon than the 3-year.
Consider a third buyer. They buy the 3-year with the aim of re-investing. To get the $563 difference between the 5-year and 3-year total interest pay-outs, they would need to buy a 2-year bond yielding 282bps when the 3-year matures [4]. If rates are lower 3 years' hence, the 5-year investor will have done better. If rates are higher, the 3-year buyer with intent on reinvesting will have done better.
This reinvestment risk, which incorporates the market's views on future interest rates, is what the yield curve essentially reflects.
[1] https://www.treasury.gov/resource-center/data-chart-center/i...
[2] 2.83% x $10,000 x 5 years
[3] 2.84% x $10,000 x 3 years
[4] [($1,415 - $852) / 2] / $10,000