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Investing Conventional Wisdom Is Always Sure, Often Wrong

Conventional wisdom says that interest rates are sure to rise. If this is causing you to stay on the short end of the maturity scale for your bond purchases, you should look a little closer. This is especially true given the very steep yield curve, which has been providing a large term risk premium.

Many investors have been reluctant to extend maturities beyond the very shortest term, thinking they don't want to be trapped if interest rates rise. I do agree that it seems highly likely the Federal Reserve will begin raising its target for short-term rates sometime this year to stay ahead of inflationary pressures. However, staying short could mean you are actually exposing yourself to the greatest risk because that's where rates could rise the most.

The reason is that a Fed tightening will certainly lead to a rise in short rates, but that doesn't mean that long-term rates will have to rise. In fact, if the Fed raises short-term rates more than expected, long-term rates might actually fall. The reason is that an unexpectedly large increase would be perceived as a tightening of monetary policy, which has positive implications for longer-term bonds. The interesting thing is that we just saw this happen a few years ago.

From 2004 through 2007, one-month bill rates rose from less than 1 percent to more than 5 percent as the Fed was tightening monetary policy. During this period:

  • One-year Treasury bills returned 3.0 percent per year
  • Five-year Treasury notes returned 3.8 percent per year
  • Long-term (20-year) Treasury bonds returned 5.7 percent per year
Thus, despite a sharp rise in rates, long-term bonds were the best place to be. Given that there's no evidence suggesting that professionals have the ability to forecast interest rates and the research shows that the best estimate of tomorrow's yield curve is today's, it seems prudent to at least consider extending maturities and earning the term premium. Of course, this should be done within the context of your investment policy statement.
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