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Inverted Yield Curve Opportunities For FAs

By David Scranton
January 10, 2023
https://www.fa-mag.com/news/inverted-yield-curve-opportunities-for-fas-71438.html?section=68

There’s good news for investors weary of seeing quarterly statements showing lackluster or negative performance: 2022 is over.

But now, here’s the bad news: 2023 might not be any better.

Recently, the S&P 500 was down by as much as 17%, while the Nasdaq fell 30%. And it’s not just about the equities market.

Even bonds have struggled, dragging down portfolios that embrace the 60/40 asset allocation approach of stocks and bonds. Indeed, many signs are pointing to an impending recession, with some economists claiming it’s already arrived.

But there’s a “loophole” of sorts that presents an uncommon opportunity in the bond market—the inverted yield curve.

Bonds: From Supporting Cast To Lead Actor

As conservative investment vehicles with traditionally low yields, bonds generally do not attract the same kind of attention as equities and alternative assets. But, because of their relative safety from volatility—compared to stocks—bonds are traditionally part of a portfolio mix. And bonds began fading into the background, until recently, as the Federal Reserve began lowering interest rates in 2008 leading to low rates of return.

Fast forward to 2022 and the arrival of inflation, which sent the Fed into overdrive by raising key interest rates to combat higher prices. Suddenly, bonds didn’t seem like such a stodgy opportunity. Yields began climbing in parallel to the Fed’s monetary policy. While equities are posting negative returns, individual bond yields are 4% to 9%.

Casting Aside History

Historically, longer-term bonds offer a higher yield because they pay investors a premium for tying up their money for 10 years or more. Until now. Bond issuers believe inflation will be tamed and the Fed will counter by lowering interest rates to avoid or counter an economic recession. With seven interest rate increases, including a half-point hike in December and signals of more to come, a deflationary scenario has yet to manifest.

With economic expectations running counter to the current environment, we now have an inverted yield curve where it pays more to hold bonds for a shorter term than longer periods. It’s been decades since there has been an inversion this wide.

A yield curve inversion tends to foreshadow a recession as it has since 1955. But if history has taught us anything, it’s that we can’t always count on history to predict the future.

Identifying Opportunity

What this means for investors in an opportunity not seen since the 1980s. For those fast-approaching retirement and heavily weighted in stocks, there may be an opportunity to move into bonds especially if short-term ones are offering 5% or 6% yields. It’s not quite the average stock-market return of 10%, but it’s better than the negative numbers we’ve seen this year.

There’s a window to act. The favorable environment will disappear once the Fed starts lowering interest rates, but that isn’t expected for the first few months of 2023.

When interest rates do come down and growth begins to outperform value, that presents another opportunity to swap out shorter-term bonds for ones with longer terms—8 to 12 years.

The Fed has signaled that Interest rates aren’t going down anytime soon. The hikes might slow, but rates won’t be cut. An active Fed coupled with an inverted yield curve presents an opportunity for financial advisors to take a closer look at income-producing vehicles like bonds.

But this window may not be open for long. It’s a good time to think about selling some equities and using the proceeds to lock in some bonds before the bond rally is over.

David Scranton is CEO and founder of Sound Income Group, a Fort Lauderdale, Fla-based, diversified financial services company.