What’s A Yield Inversion? Should I Care?

Lately, there has been talk about a yield or interest rate inversion and how such an event commonly precedes a recession. It’s true, It is frequently a sign of bad things to come. It helps to know what it is about and why it works the way it does.

Interest rate inversion

The rate you receive on an investment depends on many things. Risk is common, liquidity is another. Interest rate inversions relate to liquidity. If you give up the use of your money for longer you should be paid more for doing so. If a 10-year bond pays 2%, you would expect a 20-year bond to pay more and a 5-year bond to pay less.

That relationship is because things could change. That means more risk. Sounds reasonable.

When an inversion occurs, the short-term rate becomes higher than the longer-term rate. The usual comparison, and the one inverting now, is the comparison of 2-year bond yields with 10–year yields. Since 1900 that comparison has inverted 28 times and 22 of these were followed by a recession within a year. But not always. 1998 was the most recent false positive.

It happens because when people are concerned about the future, they tend to own more cash. Short terms are safer because they are cash sooner.

Another version of inversion.

The one you care about is the inversion from making money with your investments to losing. People care about that one and don’t always notice. Here’s how it works.

Let’s suppose you want to make a 2% purchasing power increase each year. That sounds possible. Surprisingly it isn’t easy.

It is not as easy as that. You keep only what is left over after income taxes and inflation.

If you are in a 35% tax bracket and inflation is 5% you will need to earn 10.75% on a bond to earn 2% purchasing power.

10.75% becomes 6.99% after income taxes and 2% after inflation is accounted for. That sounds impossible.

Here’s the situation.

In Canada, a 10-year government bond pays 2.5%. If you invest $10,000 and want to have purchasing power 2% more at the end of the year, you will be disappointed. Your purchasing power will have declined by 3.375% and the value of your capital will have shrunk to $9,625. It becomes very difficult to become wealthy when you lose purchasing power every year.

In times of change, holding on to ideas that worked before the change will harm you.

The key to financial success is to anticipate what will likely happen in the future and adjust your methods to coincide with what you see.

In Canada use a Tax-Free Savings Account to the extent possible. If it suits your situation a Registered Retirement Savings Plan will be tax effective. Other investments may be more appropriate. HIgh yield dividends from strong businesses should be noticed.

Bear one single thing in mind above all else. People who are paying your investment income are not altruistic. If someone offers 8% when government bonds are 2.5% you can be sure there are other factors involved that investors demand 5.5% extra to participate. Could be a risk. Could be currency fluctuation. Could be no income until the end of the time. There are many factors-upwards of three dozen. If you can’t tell why someone is paying some promised rate, dig deeper.

If a deal looks too good to be true, you are seeing it correctly.

Seek help from people who know. Investing in troubling times is not for beginners.

The bits to take away.

Investing is not easy

Manage the real after-tax return. Nominal rates don’t mean a lot. For someone in a 35% tax bracket, 5% tax-free is the same as 7.7% pre-tax. There are some inflation-protected investments.

Start early and try to anticipate where it is all going.

Keep track of your decisions and check how they play out. That’s how you learn.

Help me, please. Please subscribe. If you have found this article helpful, forward it to others.

I build strategic, fact-based estate and income plans. The plans identify alternate ways to achieve spending and estate distribution goals. In the past, I have been a planner with a large insurance, employee benefits, and investment agency, a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business. I have appeared on more than 100 television shows on financial planning. I have presented to organizations as varied as the Canadian Bar Association, The Ontario Institute of Chartered Accountants, The Ontario Ministry of Agriculture and Food, and Banks – from CIBC to the Business Development Bank.

Be in touch at 705-927-4770 or by email at don@moneyfyi.com.

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