A Crafty Way to Earn Returns From the Inverted Yield Curve

Aberrations can be vexing—and, sometimes, profitable.

The yield curve has been inverted for almost a year, an abnormal condition that will not last. Meanwhile, that has provided an opening to make an arbitrage play on Treasury securities. If all goes according to plan, the bevy of allocators and managers making this trade bank on eventually reaping lucrative price appreciation.

The maneuver centers on buying three- and five-year Treasurys. On an annualized basis, these medium-term government bonds yield a percentage point or so less than short-term debt, such as the three-month bill. But the three-year and the five-year have higher durations—which measure sensitivity to interest rates fluctuations and also govern how bond prices behave. That is where the upside resides.

The two notes have durations of around four, hence a drop in rates (usually driven by the Federal Reserve’s monetary policy) of one percentage point would result in a 4% price boost. Then bondholders could sell the appreciated bonds and book a profit. While waiting for the price pop, investors holding these notes earn 4.68% annually on the three-year and 4.39% on the five-year, as of last Friday.

A one-point drop in rates is hardly far-fetched. The projections of Fed members, as of the body’s June policymaking committee meeting, was for a dip in its fed funds rate to 4.6% next year from 5.6% in 2023. The panel meets again September 19 and 20, amid futures market expectations that it will stand pat at the current 5.25% to 5.5% band.

The Sweet Spot

Why focus on the three- and five-year notes? “This is in the sweet spot,” says Bryce Doty, a senior portfolio manager at Sit Investment Associates, who is implementing this arb play in his fixed-income strategy.

For one thing, the two medium-term Treasurys have less of a reinvestment risk than the two-year Treasury, because the three and the five’s longer maturities allow investors more time to roll over money upon expiration. The short-term two-year is more influenced by Fed actions than are the longer-dated bonds.

Second, longer-term Treasury bonds, particularly the benchmark 10-year, are less predictable and more volatile, as they are less aligned with the fed funds rate and affected more by macro forces. The 10-year’s yield has jumped around a lot: from 3.3% in April to 4.1% in May to 3.7% in late July to 4.4% recently.

The three-year and five-year, though, have seen their yields move up relatively smoothly this year, in tune with the Fed’s rate-hike policy. (That’s aside from a brief upward jolt for all government bonds in March when investors piled into Treasurys, seeking safety amid the brief banking crisis.)

The three/five play has wide appeal. “We’re doing this as a tactical matter,” says Abdiel Santiago, CEO and CIO of Fondo de Ahorro de Panamá, the Central American nation’s sovereign wealth fund (assets: $1.5 billion). “Yields are pretty attractive” for the three and five, he adds. “The yield curve will go back to normal.”

“The nominals are attractive compared with previous years,” says Lon Erickson, a portfolio manager at Thornburg Investment Management, referring to yields on the three and five. By contrast, in mid-September 2021, the three-year yielded 0.16% and the five-year was 0.27%. Hence, his firm is pursuing the arb gambit using these bonds

Falling Rate Assumptions

Of course, the built-in assumption of the strategy is that interest rates—which the Fed has jacked up to combat the post-pandemic inflation spiral—are destined to fall in the not-too-far distant future.

The conventional wisdom, buttressed by Fed Chair Jerome Powell’s remarks, is that the central bank is close to the end of its rate-increase campaign, with perhaps one more quarter-point boost left. Up to now, the Consumer Price Index has obligingly declined to 3.2% year-over year as of July, down from its 21st-century high of 9.8% in June 2022.

But what if inflation starts rising again? This could occur for any number of possible reasons, ranging from a Chinese invasion of Taiwan to an expansion of the Ukraine war, from a drastic oil-price spike to a COVID resurgence that decimates international trade.

The most prevalent scenario these days is for the U.S. economy to have a soft landing, avoiding a recession and seeing inflation subside. Sit’s Doty ticks off the factors favoring such a benign outcome: 1.6 job openings for every available worker, rising annual productivity in the second quarter of 1.3% (ending a long slide) and slowing increases in the costs of building materials, up just 0.3% this year. “The shortages that caused the inflation are dissipating,” Doty says.

Curiosities

The curious thing about the yield curve is that it has been inverted for a long time, now heading into its 11th month. According to Bloomberg statistics, the average length of an inversion is eight months, and the only two longer ones were 22 months from August 1978 to May 1980 and 14 months from September 1980 to October 1981, during the Fed’s push, under then-Chair Paul Volcker, to quell double-digit inflation. Even more curious is that the current inversion has not, as of yet, produced a recession. In every previous case, a recession followed an inversion.

To be sure, aficionados of the three/five play are hoping that the current inversion ends without a recession, allowing them to clean up as those bonds’ prices ascend.

Other strategists, however, believe that better ways exist to play the inversion. Yang Tang, CEO of asset manager Arch Indices, for instance, argues there is no assurance that the Fed, once it stops tightening, will lower rates. The Fed would do that only “because the economy has weakened significantly,” which he adds is not his “favorite view” of what will transpire.

With the curve at some point un-inverting, his math suggests that better pairings are of short- and long-term bonds (the two and the 10), short- and medium-term (the two and the five) or medium- and long-term (the five and the 30).

To Jonathan Glidden, managing director of pensions at Delta Air Lines (his plan has $15 billion in assets), an even better maneuver than the three/five would be to sell payer swaptions on the short end of the yield curve. With this instrument, the seller receives a floating rate on short-term bonds and thus is not locked into a low fixed payout should rates increase. Even then, Glidden prefers not “to get too cute,” as a lot of his fund’s bond holdings are longer-term investments designed to meet the pension obligations a decade or two in the future.

Regardless, the inverted yield curve is not a forever thing, and smart ways exist to exploit that reality.

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