Bonds & Fixed Income Investments
Using Yield Curves

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By junkman02
August 26, 2009

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The article on yield-curves at Wikipedia (linked below) is worth reading (IMHO, ‘natch), because it covers more than just the basics. However, I don't think the article goes far enough. Four major shapes are discussed: "normal", "steep", "flat/humped", "inverted". But a fifth is omitted, which I'd called "stepped". Also, the article doesn't do much to describe how a buyer of corporate bonds might use the information suggested by the various shapes a yield-curve can take. So, let's have a go at it.

Three factors explain corporate bond prices: prevailing interest-rates, company-specific financials, supply/demand. To the extent that an issuer is of high credit-quality and to the extent that its bonds are in ample supply is the extent to which its bonds are a pure play on prevailing interest rates (and not very challenging to assess). But as one goes down the credit-spectrum and as supply becomes out of balance with demand (too many or too few) is where reading the tea leaves of yield-curves can assist in making good investing decisions.

In particular, an inverted yield-curve is a clear warning sign (i.e., reliable, but not infallible) of a yet-to-be-announced Chapter 11 filing. [Explanation: The bond market has begun to price the bonds according to its estimate of a Chapter 11 workout.] Therefore, if an issuer's bonds are attractive in terms of their YTMs, but the YTM's plot an inverted yield-curve, the non-aggressive bond buyer has been given all the warning he or she needs to run the other way. This is not an issue he or she should be considering.

OTOH, if one is an aggressive bond buyer (aka, a value investor), an inverted yield-curve simply means homework time: Does the possible upside justify accepting the signaled risks? From my limited experience, the rule of thumb is a resounding "NO!" Buying an inverted yield-curve is asking for trouble. But there are exceptions that have little to do with the fact of inversion and nearly everything to do with company-specific fundamentals. If the bond market, in its collective wisdom, weren't betting that the company is in serious trouble, it wouldn't be pricing its debt as it is. But markets can over-react (to the upside and the down-side), and markets can be wrong. So, to bet on an inverted yield-curve is to make a contrarian bet that can often be justified by good fundamental analysis, good technical analysis, or just sound game theory. (Choose your poison.)

E.g., I haven't recently checked the yield-curve for E*Trade's bonds, but earlier in the year (when I was buying their bonds) it was inverted, as was the YC for Zions' bonds (I was also buying them), and both positions have done well for me (so far), as have a couple of other inversions. But, by and large, when I see an inverted yield-curve and I have no special insight into the underlying company, I automatically pass. And that reaction should be the reaction of the "average" corporate bond buyer: STAY AWAY FROM INVERTED YIELD-CURVES.

"Stepped" yield-curves, such as is seen in Sears' currently-offered debt, create an interesting puzzle. Depending on one's eye and intentions, the "sweet spot" in their YC might be the 7.5's of '13. But the anomaly in the curve is the huge step that occurs beginning with bonds due in '17 and later. Why do the 6.88's of '17 (and later maturing issues) offer 300-500 plus bps more than debt due just a couple years earlier? That difference isn't a hump or bump or an anomalous mis-pricing. It is a clearly defined step and a category of its own.

My guess (which would have to be confirmed by grinding through their financial statements) is that there is a choke point in Sears' cash flows due to their schedule of obligations. The market, through it pricing of their debt, is betting that Sears is going to gag on that choke point. So, two strategies suggest themselves: front-run the choke point (the safer path), or ride it out. The front-running could be done by buying only the debt that matures before the choke point or by being sure to exit one's position ahead it. Being able to ride out the choke point would depend on doing one's fundamental homework, so that one could be reasonably sure that the ride through the choke point wouldn't be a ride into a Chapter 11 filing, or by buying the bonds cheap enough so that the damage from a likely filing were tolerable (relative to potential gains).

Coupon Maturity YTM
7.00  02/01/11  7.3
6.75  08/15/11  7.8
6.70  04/15/12  8.3
7.50  12/15/12  7.8
7.50  01/15/13  11.0
7.05  03/15/13  8.3
6.88  10/15/17  14.2
7.50  10/15/27  12.4
6.75  01/15/28  12.9
6.50  12/01/28  13.5
7.00  06/01/32  14.6

Caveats: Lots and lots more could be (and needs to be) said about using yield-curves. But this is enough for now on rainy morning that confirms the beginning of Autumn. Also, any mention of specific issuers or bonds was done for illustrative purposes and must not be construed as recommendations to buy (or sell).