Some investors are taking the inverted bond yield curve as a warning sign of a recession. Here’s our view.

We see little reason to take a modest inverted bond yield curve as a believable signal of an upcoming recession

All they know is that bonds do tend to reduce the volatility of your portfolio, since they tend to rise when stock prices fall. Of course, bonds also generate more commission fees and income for the broker, compared to stocks, especially if you buy them via bond funds and other investment products.

That’s why we continue to recommend that you invest only a small part of your portfolio—if any—in bonds and fixed-income investments. Instead, you should aim for a diversified portfolio of well-established companies with long histories of dividends, or ETFs that hold these stocks. 

Meanwhile, sometimes the bond market shows an “inverted bond yield curve”: that is, interest rates on short-term bonds are higher than long-term rates. Some people take this to mean that the bond market is signaling an upcoming recession. That’s a possibility, as recessions have followed some past inverted yield curves. Here’s more on that:

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We don’t see a modest inverted yield curve as a believable signal of an upcoming recession

The “yield curve” is a graph that shows how interest rates vary in relation to the “term” or length of a loan. The left side of the graph shows the interest rate, rising from bottom to top. The bottom side of the graph shows the loan’s length, from short at the left to longer at the right.

A “normal” yield curve is a situation where the graph shows a rise from the lower left to the upper right, which means longer loans carry a higher rate of interest. It’s called normal because, typically, the longer a loan lasts, the higher the interest rate.

However, in past inverted bond yield curve instances, the yield difference was bigger—typically several points higher at the short end of the market than at the long end. Today the “inversion” is a fraction of a single percentage point (1%) of the value of the loan or bond.

My view is that the possibility of a recession rises with an inversion in the yield curve only if the inversion is due to a shortage of short-term credit availability. In that case, borrowers who want short-term loans have to bid against each other; this pushes up interest rates at the short end. Long-term rates remain lower because borrowers and lenders share a couple of beliefs: they think all interest rates will come down substantially, but that short rates will fall more than long-term rates, since the yield curve has a natural tendency to revert to the “normal,” or typical, arrangement whereby long-term loans carry higher interest rates than short-term loans.

Sometimes, the predicted recession fails to arrive. The inverted yield curve may revert to “normal” if short-term rates fall, or if long-term rates rise.

I see little reason to take a modest inverted bond yield curve as a believable signal of an upcoming recession, for two reasons.

To begin with, the inversion is minor—just a fraction of a single point.

Moreover, inverted yield curves only worked as a recession omen in cases where central banks aggressively pushed short-term rates up, to fight inflation. Often, inflation stayed high until interest rates went high enough, long enough, to trigger a recession.

When inflation is too low it does not worry central bankers—they were more concerned about the upcoming recession. So, they pushed long-term rates down, merely as a way of maintaining economic growth.

Central bank tinkering with money markets is becoming less effective as a way to control the economy. That’s all the more reason to doubt rules based on past decades when central-bank tools worked as intended.

Invest cautiously in the bond market and bond funds, if at all, to preserve your capital

When bonds yielded 10%, perhaps it made some sense to buy bond funds and pay a yearly MER of, say, 2%. Now that bond yields are substantially lower, it makes a lot less sense.

The bond market is also highly efficient, and few managers can add enough value to offset their management fees. But investing in these funds exposes you to the risk that a manager will gamble in the bond market and lose money.

Inflation is another threat to bond funds. If the funds hold their bonds to maturity, they will get back the bonds’ full value—but inflation will have cut the purchasing power of the bond’s face value.

Note that as a general rule, the safest bonds are issued by or guaranteed by the federal government. Next come provincial issues or bonds with provincial guarantees.

Corporate bonds are far riskier than government bonds, and the risk on corporate bonds, varies widely. Some corporate bonds are almost as safe as government bonds and offer only slightly higher yields. Some corporates are far riskier and offer far higher yields.

Use our three-part Successful Investor approach to make better investments across the board

  1. Hold mostly high-quality, dividend-paying stocks.
  2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance, and Utilities.
  3. Downplay or stay out of stocks in the broker/media limelight.

What outlying factors do you consider when thinking about the possibility of a recession?

How does the talk of a recession alter the way you invest?


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