In this month’s edition of “Money Matters,” Scott Oeth explains the frequently overlooked bond market, the inverted bond yield curve, and why investors should consider the bond market’s investment opportunities.

Many investors see yield curve inversions—when short-term bond yields exceed long-term yields—as foreboding. Do they signal a stock market downturn? Data from the U.S. and other major economies show yield curve inversions have not historically predicted equity market downturns. As markets incorporate news and events around the world, bond yields change, which causes yield curves to change. Historically, the U.S. Treasury yield curve has generally been upward-sloping; however, during several periods, the curve inverted. What can we learn from these examples?

The inversion prior to the 2008 financial crisis is an interesting case study. As shown in the chart below, the U.S. yield curve inverted in December 2005, which was followed by a positive 12-month return for the S&P 500 Index. The yield curve’s slope shifted positive again in June 2007, well prior to the equity market’s major downturn from October 2007 through February 2009.

Investors who interpreted the inversion as a sign of an imminent market decline and pulled out of stocks could have missed subsequent equity market gains. If those same investors had bought back into stocks when the yield curve’s slope became positive, they would have also been exposed to the market downturn that followed. (Courtesy of DFA)

Money Matters: The Bond Market Transcript

0:00:00.0 CJ: WTIP is pleased to bring you another edition of Money Matters, it's a monthly feature intended to help us understand more about managing our finances. Scott Oeth is a certified financial planner and adjunct professor. He's taught retirement planning and wealth management strategies to hundreds of financial professionals. And Scott joins us now by phone. Welcome, Scott.

0:00:23.8 Scott: Good morning, CJ.

0:00:24.8 CJ: Good morning to you. So, you'd like to talk to us a little bit about bond investing, maybe you can start us off with just a quick refresher on bonds.

0:00:37.6 Scott: Sure, yeah, sounds like a great idea. And I will throw out, since we're talking specifically about investment strategies, you know I need to... My compliance department wants me to put out a disclaimer, this is generalized conversation here, and people should really seek their own professional, personalized advice, and we're just talking from an educational standpoint here. No specific recommendations. But CJ, bonds, it's a fairly simple idea, but they can be remarkably complex. [chuckle] Okay, and I find people hear the term, but sometimes don't really understand just the basics, and when you buy bonds in your retirement accounts or your IRA or your broker's account or you hear people talk of buying bonds, what they're really doing is they're loaning money either to a corporation, or a governmental entity.

0:01:29.2 Scott: So these governments might need to raise money for a bridge project or a hospital, or universities or airports or things like that, so there's a wide variety of different types of government debt or bonds where they're issuing contracts to say, "CJ lend us some money, we'll give you interest payments over time and then we'll pay you back in full at the end." Or a corporation certainly do the same thing, you know, if they need to raise capital to expand or to finance their operations. They can issue stock, which is selling part of the company, the equity in the company and we talk about that a lot.

0:02:02.8 Scott: I'm probably guilty of talking more...a lot more about stocks than I do about bonds. But the other way that companies can raise money is to issue bonds and that's typically cheaper for them, they're not really giving away the upside growth, they're just committing to paying those investors back. So, not a new idea, bonds have been around, it's been a thing for almost a thousand years going back to ancient Venice. To raise money they would tax citizens and they started issuing bonds where they pay back with interest as well. And you know, even though bonds are may be neglected, somewhat in the media and conversation, and in our Money Matters chats. The bond market is actually much larger than the stock market.

0:02:46.1 CJ: Really?

0:02:46.4 Scott: Global stock market is about $30 trillion, but the bond market is almost 25% larger, it's about $40 trillion. You just don't hear about it as much. It doesn't generate the headlines, typically with the wild swings, a lot of bonds are traded directly over the counter between the issuers and the people buying, and so a couple of reasons, but a very large market and can be a very, very important part of the investor strategies.

0:03:12.7 CJ: So why would someone choose to invest in bonds instead of stocks or real estate or other types of investments?

0:03:21.4 Scott: Yeah, there's a couple of reasons, and I think sometimes, you know I talk about bonds, I get that feeling, it's like trying to get my little boy to eat his vegetables. [chuckle] You know, it's just not as exciting, and people don't always get real fired up about buying bonds. Now that varies, some people really like the idea of bonds, and a couple of the main reasons bonds are a promise to be paid back. And so capital preservation, you know, if you have a certain amount of assets and you're comfortable with that is enough to accomplish what you want to do in life, or there's this very specific goal that you want to match up your dollars with that timeline and that goal, bonds can play a wonderful role, they can preserve capital, they can provide dollars at a specific point in time with a higher degree of certainty than some other types of investments.

0:04:14.5 Scott: Bond portfolios... Traditionally, historically have proven nice income producers, you could buy a collection of bonds and they can provide interest payments over time so you have a regular income. And there's a lot of different ways you can do that CJ, you could buy the bonds directly, so the individual bonds, you could buy them in a basket in what's called the mutual fund structure or an exchange triggered funds so there's different ways, and probably a lot of listeners own bonds but they might not even realize it, inside 401k plans or 403 [b] plans or the very common company-sponsored retirement plans. There is often what's called target date funds or asset allocation funds or balanced funds, and many of those have significant bond positions. So bonds can reduce the volatility on an overall portfolio, they can provide a safe... Safer haven to match up with near term spending, and so lots of good reasons why someone might want to buy bonds.

0:05:12.1 CJ: Okay, but how much control do you have over when you get your money back?

0:05:20.0 Scott: Well, you can dial it in and be very specific, you know, at times, if I'm working with someone and we know that there's a major financial need that's coming up in a few years, maybe it's a tuition payment or wanting to buy a home or... Something along those lines, we can dial it in very specifically, and you can get into what bond investors call your asset liability match, and where we can look at the date and say we want the maturity, which is a measure of the interest rate, maybe it kind of gets deep in the mathematics of bond investing. But we can line that up pretty specifically, you know, more simple context, you could say, okay, we need money in 2025, so maybe what we might consider is looking at some bonds that all mature in, say, 2024, maybe even 2025, you really want to measure the potential risk, and you could buy those so that they come due. And so, they mature, you receive interest payments in the interim, and then money shows up as those bonds reach maturity. So it can be a very nice way to match up that timeline.

0:06:29.0 CJ: But it's not turn on a dime kind of thing, you've got to be pretty... You got to map it out pretty carefully.

0:06:38.2 Scott: Well, you do with most types of bonds, whether it's in a bond fund or being held directly, you could usually sell at any point in time during a trading day, there's that type of liquidity, but if you're selling before maturity, there's some uncertainty as to what the price of the bond may be. As they're traded throughout the day before they reach maturity bond prices do float up and down, like stock prices or real estate prices, or timber or pork bellies or whatever we're talking about, there can be fluctuations, and with bonds, those fluctuations can really depend on what's happening in the interest rate environment, and then you also look at the credit quality of the borrower, it's just like CJ, if I said, Hey, can I borrow $10, I'll pay it back after lunch? You might say, you know, okay, that's a reasonable risk. I'm gonna see him, I know where he's hanging out, and I'll probably get my $10 back, but if you don't know me very well or maybe you've heard not great things about my character or my reputation, I say, CJ hey, can I borrow $10 bucks I'm gonna go hitch-hike across the country, I'll be back sometime next year and pay it back. You might say, Eh.

0:07:52.7 CJ: No way, Scott.

0:07:53.0 Scott: I don't know if I like the prospect for that. Exactly, exactly. So it's the same thing with bonds. Analysts can look at companies or look at governments, and look at their credit quality, that's a factor in bond pricing, and also the maturity or how long they're asking to borrow the money for.

0:08:10.2 CJ: Okay. Alright, well, thanks for recapping what bonds are all about. But what's happening right now with bond investing, and why do you think this is a timely topic for us?

0:08:21.0 Scott: Yes, so big picture, bonds are viewed as safer than stocks, okay? They are promised to pay back where stocks are this uncertain ownership stake. Because of the natural risk return trade-off in the market, bond returns are traditionally lower than stocks, but they're also traditionally less volatile and safer. But as we sit right here, bonds have had a very bad first quarter of the year, US fixed income, bond market is down almost 6% for the first quarter of the year, and a lot of global... What's called high-yield bonds are down about the same, and that's... There's this term, flight to quality investors moving out of what might be riskier assets and into safer ones, and so that credit quality issue with the Russia-Ukraine conflict, more money has moved into the safer categories of the bond market. So bonds have had a rough quarter, their worst one in a long time. There's that, and then there's this other concept of what's called the yield curve, and that is analysts will map out the yields that bonds are currently paying, and across the horizontal access would be a timeline, and vertical going up and down would be the yield.

0:09:43.3 Scott: And normally this looks kind of like the first half of a rainbow, the curve slopes upward over time, so the longer you're asking to borrow money for, the higher the interest rate would be. Well, it's fairly rare, but at times that curve becomes inverted. And so this is a headline that's in the financial news right now is, the yield curve, short-term interest rates on bonds are exceeding longer term ones. And so this is causing quite a bit of talk, and speculation, and worry because this could be a sign that investors are accepting lower rates on long-term government debt because they're concerned about the prospects of the economy, and that the fed reserve, it's raising interest rates to fight inflation, and that in doing so, this could trigger a recession. And there's pretty good reason to worry because this inverted yield curve in the past has many times been an indicator of a recession. So I want to bring it up because it's being talked about a lot, and there's a lot of concern that this is a signal of a recession.

0:10:54.5 Scott: But I'd also urge caution, and to be aware of false alarms, okay. It could mean this, it is a risk to monitor, but if we look further back, it often says, going back into the '70s, inverted yield curves have signaled recession, and that statement will be put out there. But if we really dig deeper, we look back into the '50s, there were many times where there were recessions, 1957, '58, '60, '61, where the yield curve did not invert before those recessions. And 1966, there was a yield curve inversion and there was not a recession afterwards. So it's not perfect, it's not every time. I think it is something to think about. Are you in good financial position? Is your financial house in order? Do you have some emergency savings? Think through, unfortunately what might happen if there's a job loss or a pay cut. Be very thoughtful about taking on debt or committing any unnecessary expenses, really trying to have your financial house in order in case this is an indicator of an economic slow down.

0:12:06.4 Scott: Many people correlate that with stocks saying, Oh, there's a risk of recession, we should get out of stocks. And I just don't think... My view generally is stock should very much be long-term holdings in your portfolio, and when you look historically at three and five-year returns of stocks after yield curve inversion, the returns often look very good. So again, this is just generalized advice, seek your own personal professionalized analysis, but it's something to be mindful of, and I'd say consider your financial position, but it's... Yeah, I think the idea of be aware of false alarms is also a play here.

0:12:49.0 CJ: Yeah, so don't panic and be thoughtful in what you do.

0:12:54.9 Scott: Yes, exactly. As good a time as any to analyze your position, see what is your bond market exposure, what types of bonds are you holding, are they suitable? What about your overall stock to bond mix, is that appropriate for where you're at? And near-term, are you prepared for a negative financial event? Do you have some savings? Do you have access to emergency funds? Access to emergency credit? If things took a turn for the worst, what would be the expenses? Where would you tighten the belt? What would you cut back on? You have to develop a plan.

0:13:30.3 CJ: Well, thank you Scott, it's always a lot to take in and process, and we appreciate any help we can get on this financial money matters.