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How to Play the Flat Yield Curve

The Federal Reserve may think inflation is rearing its ugly head. But, most other people apparently don’t share this view.

Since the Central Bank began tightening in June 30, 2004, it has lifted short-term rates by two percentage points, or 200 basis points, to 3 percent.

At the same time, the yield on the 10-year note fell 60 basis points to 3.98 percent. The result: A flattening yield curve.

What should investors do? Certainly, don’t ask Fed chairman Alan Greenspan. He called the decline in the yield on the 10-year note a “conundrum.”

“We believe strong demand on the part of foreign investors and U.S. pension funds for high-quality, long-duration assets is partly responsible for the drop in intermediate and long-term Treasury yields,” UBS recently explained to its clients. “In addition, hedge fund buying may also have contributed. Although the curve may flatten a bit more in the months ahead, we believe most of the flattening has already occurred.”

So, it recommends that investors stay short. “The incremental gain from extending out the curve is not commensurate with the increased risk,” it adds.

It suggests that if the bulk of the flattening is in fact behind the Treasury market, “a laddered portfolio structure should outperform a barbelled allocation.”

“We believe accelerating inflation pressures and sustainable economic growth will keep the Fed in a tightening mode over the balance of the year,” it adds. “Against this backdrop, longer-term treasury yields should move higher.”

It looks for the yield on the 10-year treasury to approach 5 percent by year end. “As a result, we are maintaining our call to underweight duration,” it adds.

Merrill Lynch points out that it is more likely we’ll see 4.5 percent than 3.5 percent in the near future. “While we have lowered our sights as to how high yields could go, we still believe that investors should approach the market with some degree of caution,” it adds in a recent report.

The story is different when it comes to corporate bonds. UBS notes that spreads are near their tightest in eight years. As a result, the brokerage believes there is “limited” potential for significant spread compression, “especially given our expectations for a less favorable fundament environment latter this year.” So, it recommends investors take a market weight position.

Although it recommends modest underweight of high yield bonds, UBS does assert, “At current spreads, we see little leeway for negative events and limited room for significant upside.”

Another way to take advantage of the flattening yield curve is to move further into municipal bonds. “We continue to believe that municipals offer the best value in the bond market for U.S. taxable accounts,” says Merrill Lynch.

“With long-term rates continuing to decline, muni yields have stayed higher than Treasuries—and munis have finally become ‘cheap’ compared to taxables,” according to a recent report from Smith Barney.

For one thing, between the end of March and May 19, 10-year Treasury yields fell 39 basis points, while 10-year muni yields were down 34 basis points.

What’s more, high-grade 30-year muni yields as a percentage of Treasury yields are now about 99 percent, within a hairsbreadth of the highest yield ratio in the past 10 years, the brokerage points out. On all other maturities, the yield ratios are also near the highest levels of the past 12 months, it adds.

Merrill Lynch recommends extending out to the 15-year plus segment of the yield curve. And, as the Fed moves closer to the end of the tightening cycle, the brokerage suggests that investors consider beginning to move out of money market instruments and into the 2-to-3-year segment of the yield curve.

In general, Merrill suggests that investors who have profited from flattening yield curve strategies should consider using opportunities to reverse those positions. “We believe that the Fed will pause soon, and that the yield curve will eventually steepen again, making curve-flattening strategies less profitable and, eventually, unprofitable,” it adds.

Lehman, on the other hand, takes a different approach. It essentially counsels investors in general not to dwell on the flat yield curve and its significance.

It elaborates: “As we all know, the overall altitude and shape of yield curves have been found to be highly correlated with business cycles. Flat and inverted yield curves often presage soft and even contractionary economic conditions. Steep yield curves usually can be bound at cyclical bottoms and at early stages of economic recoveries. While major movements in yield curves, often engineered by monetary authorities, can be correctly associated with concurrent and anticipatory cyclical wind shifts, the temptation to divine vast significance in more minute curve oscillations has become overdone in our view.”

Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years