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<br />
<br />YIELD CURVE INVERSION:
<br />WHY LONG~TERM STRATEGY MATTERS
<br />
<br />An inverted yield curve occurs when short term
<br />interest rates are higher than longer term interest
<br />rates. While such scenarios do occur periodically, they
<br />are not common and generally last for a relatively
<br />short period of time. When these inversions occur,
<br />some investors attempt to time the market by
<br />investing in higher short term rates. They then hope
<br />to be able to invest in longer term securities when the
<br />interest rate curve normalizes, creating a situation
<br />where they can time the market. While this is a great
<br />strategy if it works, the reality is that over time, the
<br />vast majority of investors are much better off if they
<br />refrain from attempts at predicting bond market
<br />fluctuations and instead consistently adhere to
<br />proven strategies that have a strong historical track
<br />record.
<br />
<br />One strategy that has performed well over an
<br />extended time horizon is to hold longer duration
<br />portfolios whenever
<br />possible. For the past 12.00%
<br />fourteen years, this
<br />10.00%
<br />strategy has been
<br />very successful for 8.00%
<br />investors. As the
<br />6.00%
<br />graph demonstrates,
<br />from June 1992 4.00%
<br />through June 2006, 2.00%
<br />the three year rolling
<br />returns of the Merrill 0.00% '" '" ... '" '" ....
<br />Lynch 1-5 Year ~ ~ ~ ~ ~ ~
<br />Government Bond ...,...,...,...,...,...,
<br />I n d e x w ere - 3 mo r-BiII Benchmark
<br />consistently higher Source: Merrill Lynch
<br />than the rolling returns for the Merrill Lynch 3 Month
<br />T-Bill Index. Even during periods when the total
<br />return of the 3 Month T-Bill Index was higher than
<br />that of longer duration portfolios, the
<br />outperformance was slight. In contrast, there were
<br />many times that the 1-5 Year Government Bond
<br />Index dramatically outperformed the 3 Month T-Bill
<br />Index.
<br />
<br />average annual return of the 1-5 Year Government
<br />Bond Index was 5.29%. Despite very short periods of
<br />underperformance, the 1-5 Year Government Bond
<br />Index outperformed its shorter cousin by an average of
<br />130 basis points per year overthe 14 year period.
<br />
<br />To put this into dollars and cents, if a $50 million
<br />portfolio had been invested in the 3 Month T-Billlndex
<br />in June 1992, it would have grown to more than $86.5
<br />million by June 2006. If, on the other hand, that same
<br />$50 million portfolio had been invested in the 1 ~5 Year
<br />Government Bond Index, the portfolio would have
<br />grown to more than $100 million dollars!
<br />($102,868,591 to be exact)
<br />
<br />co
<br />'"
<br />C
<br />::l
<br />...,
<br />
<br />Let's step back and look at this again for a moment. The
<br />1-5 year portfolio generated excess returns of more
<br />than $16 million dollars when compared to the 3
<br />month portfolio. This is a fairly amazing number,
<br />particularly when
<br />we stop to consider
<br />that all that the
<br />portfolio held was
<br />short and
<br />intermediate
<br />term government
<br />securities. If an
<br />investor chose to
<br />extend their
<br />en a '" '" CD duration even
<br />~ ~ ~ ~ ~ ~ ~ ~ further, or to take
<br />~ ~ ~ ~ ~ ~ ~ ~
<br />..., ..., ..., ..., ..., ..., ..., ..., on a measure of
<br />credit risk by
<br />holding high-grade
<br />corporate bonds in
<br />addition to government bonds, portfolio performance
<br />would likely be even higher overtime. This is due to one
<br />of the most important rules of investing: over time
<br />investors that take on greater risk have the
<br />potential to earn higher returns. In the example we
<br />are looking at, simply by taking on additional interest
<br />rate risk by extending portfolio duration, and by
<br />foregoing the temptation of reaching for the highest
<br />yields possible during those times when the yield curve
<br />was inverted, an investor could have generated an
<br />extra $16 million fortheir constituents.
<br />
<br />
<br />Three Year Rolling Returns
<br />
<br />In fact, there have only been two periods during the
<br />preceding 14 years when the rolling three year
<br />returns for the 3 Month T-Billlndex was higher than
<br />that for the 1-5 Year Government Bond Index. One
<br />such period occurred during the second half of 1996,
<br />and the other has occurred during the past twelve
<br />months. However, for the vast majority of the last
<br />decade and a half, longer dated securities have
<br />outperformed.
<br />
<br />Over time, the differences in performance are
<br />staggering. For the fourteen year period from June
<br />30, 1992 through June 30, 2006, the average annual
<br />return on the 3 Month T-Billlndex was 3.99%. The
<br />
<br />-1-5 Year Gowmment Benchmark
<br />
<br />The key to achieving these excess returns is to select an
<br />appropriate strategy and then stick with it over the
<br />long haul. Right now, while there is an obvious
<br />temptation to chase the highest rates on the yield
<br />curve, historical evidence indicates that maintaining
<br />investment discipline by holding a longer duration
<br />portfolio can be the key to long term investment
<br />success.
<br />
<br />-Brian Perry is a Research Analyst at Chandler Asset Management
<br />
<br />Page 2
<br />C> 2006. Chandler Asset Management, Inc, A Registered Inve.tment Adviser.
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