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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   May 2007

Navigating the Yield Curve

The shape of one simple line on a graph can have a big impact on investors’ decisions

Navigating the Yield Curve

With new lenders and brokers rapidly entering the commercial lending industry, it is important to separate yourself from the competition. One way is to position yourself as an adviser to your clients.

Understanding the industry and its driving forces is the first step in doing that. Predicting what interest rates may do in the future is one of the most-important factors in gaining that understanding.

The yield curve is one of the most-reliable ways to forecast which direction interest rates may be headed in the near future. Armed with a solid understanding of the different kinds of yield curves, you can help your clients decide whether to fix in the rate long-term, which prepayment penalty structure to choose and the amount of leverage that would be optimal.

Ultimately, this will help you guide your clients regarding which loan products will benefit them today and in the future.

Deciphering the data

The yield curve is the relationship between the current yields (interest rates) on Treasury bills and notes. It is charted from the three-month Treasury bill to the 10-year Treasury note. Its shape can help determine where the economy and interest rates are trending.

To read the yield curve successfully, it is helpful to understand the relationship between the price and the yield of fixed-income investments. As is the case with stocks, greater demand drives up the price of these investments as they are bought and sold. Because their yields are fixed, the higher price paid for them effectively lowers their yields.

If you pay $1 for a bond that pays 6 percent and then sell it at $1.10, the purchaser is not receiving a full 6 percent because the yield is fixed at 6 percent of $1. The new purchaser receives only 5.45 percent, which is the new effective yield.

This also works in the opposite direction. As demand for the bond drops, it results in lower prices and higher effective yields. Because many interest rates are priced at a spread over these yields, this explains how demand for Treasuries and mortgage bonds affect many of the interest rates with which we work.

With this basic understanding, it is easier to evaluate the different shapes of the yield curve. Here’s a look at three common shapes.

Normal curve

A yield curve with a slight upward slope is considered normal. A normal curve indicates that investors expect the economy to grow at a steady rate and inflation to remain under control. As a result, significant changes to interest rates are not expected.

In this scenario, shorter-term fixed mortgage rates typically will be priced better than longer-term rates. Borrowers will face the same risk-versus-reward decision as Treasury-bill investors, albeit in an opposite way.

Borrowers who lock in short-term or opt for floating rates will face greater risk than those who pay a premium for long-term fixed rates. The length of time they will hold the property and the amount of cash flow they must generate will be the primary factors in how to advise your clients.

This is a reflection of how investors view the risk-versus-reward relationship of these investments. Investors who purchase three-month Treasury bills are only tying their money up for a short time. Therefore, they require less compensation for doing so.

Longer-term investments, however, such as the 10-year note or 30-year bond require investors to tie up their funds longer. These investors require more reward for the fluctuation risks that occur in the bond prices during the period before they mature.

Steep upward curve

A steep upward-sloping curve indicates that long-term investors believe that the economy will improve quickly. This, of course, brings fears of inflation, which the Federal Reserve will try to control by raising interest rates.

In this case, investors often fear being locked into low rates, and they opt not to purchase long-term fixed notes. The lack of demand drives up their yields, which causes a wider gap between the yields on the three-month and 10-year Treasuries.

This is typical after a recession. Even though longer-term, fixed loan products will be priced considerably higher than shorter-term variables, this is a good time to lock in rates because rate increases will typically occur across the board.

Flat and inverted curves

A flat curve indicates investor uncertainty. Historically, this curve has signaled an economic slowdown.

Flat curves sometimes will turn into inverted curves, where long-term yields are lower than short-term yields. This is a situation where investors are actually willing to accept less return for the risk of tying up their money for longer periods.

Investors believe that this situation indicates the final time they can lock in higher long-term rates before rates fall. They also believe that inflation, which erodes the returns on these investments, will remain low because of a slower economy.

It is important to note, however, that not all flat curves result in inverted curves, and not all inverted curves result in a recession. This is especially true when rates have remained low during a period of economic growth, which has been the case during this most recent expansion. Inverted curves, however, can be a good indicator of lower rates in the near future.

Because borrowers in these periods do not have to pay a premium for longer-term fixed rates, other factors become more important when advising these clients on the right loan program. And because prepayment penalties often match the fixed terms of loans, this is one good example of how these factors can help choose which loan programs to consider during these periods.

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Whether you are working with a business-owner, a novice or a seasoned investor, it is just as important to be focused on taking care of your clients as you are on your commission check. Understanding the forces that drive the industry will assist you when advising your borrowers on which products best suit their needs. This not only makes for an easier closing, but it also builds clients for life.


 


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