Never Underestimate the Power of Graphs

Recently, my uncle, John Valentine, and I were enjoying lunch while discussing the Olympics. "If you were participating in the Olympics, what would you win a gold in," I asked him, "boxing or badminton?" My question made him chuckle. "The best chance I would have to win a gold would be in understanding the yield curve," he responded.

Unlike Uncle John, I would come in last if understanding the yield curve were an Olympic event. That's because every time I hear the phrase "yield curve," a graph is drawn and financial gibberish spouts from the mouths of those discussing the topic, leaving me feeling lost. Due to pure frustration, I decided to do research on the topic. In Olympic terms, this article is a very basic somersault—not a triple somersault with a twist.

Yielding Understanding

At first glance, the yield curve looks as simple as tic-tac-toe. Interpreting it, however, can be as tricky as playing with a Rubik's Cube. Therefore, let's start with the basics. A yield curve is a graph that represents the relationship between the yield (ie, the annual rate of return on an investment) and the maturity of a security (ie, the length of time until the principal amount of a security must be repaid). It can be created at any given time and for any given securities, including stocks, bonds, mutual funds, and CDs.

The yield curve portrays yield differences, which are caused by varying maturity dates (ie, the end of a security's life). These curve trends are used to compare yields of different securities, benchmark interest rates, and discover yield curve trends. Analysts use the yield curve to understand market conditions, while economists use it to understand economic conditions.

Financial Forecasting

The yield curve plays a significant role. It is an essential indicator of monetary policy and future economic conditions, determining the interest paid on borrowed money as well as the interest earned by investments. It also helps determine portfolio strategies. Since the shape of the curve affects stocks as well as bonds, it helps financial advisors figure out when it's time to reallocate and/or rebalance an investor's portfolio.

So, what actually determines the slope of the curve? Ultimately, there are two factors that affect the slope of the yield curve: investors' expectations for future interest rates and the impact of risk premiums on long-term bonds. Now, due to the fact that the yield curve is affected by both of these factors, understanding the curve can be difficult. Today's economists and portfolio managers put great effort into trying to understand what forces are driving yields at any given time and point on the curve.

Terminology

note:

Pinpointing what forces are driving yields is made even more difficult by the fact that the yield curve is constantly shifting and changing. There is a difference between a shift and a change in the yield curve. A shift in the yield curve is a jump in the curve. In this case, the entire curve, including the first and last points, shifts upward or downward. On the other hand, when there is a change in the yield curve, only the first or last point of the curve moves, not both points.

Acknowledging the Game

Often, physician-investors choose a method for investing in the bond market by simply examining maturities. These investors ladder maturities (ie, evenly divide money among bonds that mature at regular intervals) when interest rates are rising. However, the same investors also ladder maturities when interest rates are falling. Subsequently, they're constantly laddering maturities. Unfortunately, this strategy doesn't work in all markets.

How could a single strategy be effective in all markets? Imagine being a football coach and instructing your offense to pass the ball every play of every game. Eventually, all of the other teams in the league would catch on to your strategy and it would become impossible for your team to win. The same thing holds true for the market. You can't simply use the same investment approach in all markets. That's why a yield curve is important. It gives financial advisors a foundation and basis for future strategies and recommendations. In addition, examining the history of yield curves can also help advisors determine future market strategies.

Looking to the Future

When it comes to yields, the future looks rather bright. In fact, long-term yields should inspire a wave of confidence in the economy. Over the next few years (ie, 24 to 36 months), the yield curve should maintain an upward curve. A shift, and not a change, will most likely occur and 1-year to 20-year bonds will shift upward. Of course, this will only happen if the US economy and the gross domestic product remain robust year after year.

There are many strategies you can employ in the next few years to capture yields and not give up principal. Meet with your financial advisor to discuss all of your options.

has a strong background in

ethical research and the investment industry. She

works full-time for the Valentine Capital Asset Management

of San Ramon, Calif, and is the

chief editor of their "High Net-Worth Newsletter,"

published monthly. She is currently working on her

master's degree in ethics. She welcomes questions or

comments at 925-275-0200 or visit www.vcrpg.com. This article was produced with contributions

by John Valentine.

Genevieve Valentine