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In an inverse yield environment, investors face a challenging landscape where the traditional relationship between risk and reward is turned upside down. Usually, when you invest in short-term debt instruments, you receive a lower interest rate, and when you invest in longer-term debt instruments with longer maturities, you are rewarded for that with higher interest rates. During an inverted yield curve, the opposite happens, and interest rates are higher for shorter term debt and lower for longer term debt. The primary cause of an inverted yield curve is the Fed raising rates beyond what the market participants are anticipating will be reflected in long-term rates. Said another way, the Fed’s adjustments to the Fed Funds Rate generally have a direct effect on short-term rates, and broad investors have more control over long-term rates.
The Fed generally increases rates when it is trying to control inflation and slow down an overheating economy, and the converse is also true. However, long-term rates generally reflect the long-term views of bond investors in general, including views on future interest rates and long-term interest rate expectations and volatility. If the Fed believed the economy was starting to cool too quickly and needed some support, it would generally decrease the Fed Funds Rate. Therefore, when there is an inverted yield curve, it may be representative of a Fed that has increased rates at a faster pace and by a larger amount than what the longer-term investors believe is likely to persist. This often signals economic woes ahead, and in such periods of uncertainty preserving capital becomes a primary concern for investors seeking to maintain the value of their portfolios while generating sufficient returns to stay ahead of inflation. In this article, we will explore several investment options that can help navigate an inverse yield environment and preserve capital effectively.
In an inverse yield curve environment, investors face the challenge of finding safe and effective ways to preserve capital while generating reasonable real returns (i.e. returns that are higher than the rate of inflation). Some popular options often considered are Certificates of Deposit (CDs), Treasury bills and bonds, and traditional bank deposits. These instruments offer relative safety of principal compared to other investments, but they come with their own challenges during an inverse yield curve environment and a set of advantages and disadvantages. In this article, we will explore how using brokered CDs, Treasuries, and bank deposits can help navigate an inverse yield curve and examine the pros and cons associated with each.
Brokered CDs: The Upsides and Downsides
Brokered CDs are time deposits offered by banks but sold through brokerage firms. They have specific maturities and fixed interest rates, making them an appealing choice for capital preservation.
Pros:
Higher Yield Potential: Brokered CDs often offer higher yields compared to traditional bank deposits, especially during an inverse yield curve. This is because they offer higher rates for shorter periods of time. In normal periods you are rewarded for longer-term CDs but during an inverse yield curve, you may still see very attractive rates in the short term without needing to lock up your money for long periods of time. Additionally, brokered CDs can be sourced from various banks across the country, allowing investors to access competitive rates.
Secondary Market Liquidity: Unlike traditional bank CDs, brokered CDs can be sold on the secondary market before their maturity date. This feature offers investors increased liquidity if the need arises to exit the investment early.
FDIC Insurance: Just like regular bank deposits, brokered CDs also carry FDIC insurance, offering protection against bank defaults up to the insured limit (currently $250,000 per depositor, per insured bank, for each account ownership category).
Cons:
Early Withdrawal Penalties: Brokered CDs typically have substantial early withdrawal penalties, which can eat into returns if the investor needs to access the funds before the CD's maturity.
Complexities: Brokered CDs can be more complex than traditional bank CDs, with variations in features, terms, and conditions depending on the issuing banks. Investors need to carefully understand the details of each offering.
FDIC Insurance: While a $250,000 per account holder FDIC insurance protection is generally a positive attribute, high net worth individuals would need to purchase and manage several brokered CDs from different banks to be able to achieve maximum coverage, and managing this can be cumbersome.
Treasury bills & bonds: An Attractive option for certain investors
Investing in Treasury bills and bonds can be an attractive option for certain investors due to several compelling reasons. Returns are predictable as long as the bill or bond is held to maturity.
Pros:
Safety: There is a very low risk associated with Treasury bills as they are considered among the safest investments issued and backed by the US government.
No Fees or Commissions: When purchasing Treasury bills and bonds directly from the government, investors typically do not incur any fees or commissions. This means you can invest your full amount without any deductions.
Cons:
Duration Risk: Treasury bills typically have short maturities, which can work out nicely during an inverted yield curve, but Treasury bonds with longer-term maturities may be sensitive to changes in interest rates. For example, if interest rates rise after you purchase a Treasury bond, the market value of your bond decreases, and this is especially pronounced during an inverted yield curve when shorter-term bonds pay higher rates than longer-term bonds. The higher yield on the shorter-term bonds is used to reprice the bonds as their time to maturity naturally shortens as time goes on. Therefore, if the yield curve inversion is prolonged, then bonds that migrate into the shorter maturity bands have a slight headwind due to entering a higher-yielding segment of the curve. The risk of exposure to long-term maturities arose during the recent banking crisis when Silicon Valley Bank invested in long-term Treasury bonds. During the time of their investments (primarily 2020 and 2021), this may have made sense with near 0 interest rates, but as interest rates increased dramatically, the value of those bonds dropped significantly, causing a significant mark-to-market loss to the bank and a large adverse disruption in their relationship of assets to liabilities. In addition, a bank’s liabilities are generally comprised of short-term deposits, so as those short-term rates rose from near-zero to substantially higher than what their long-term assets were yielding, it also affects their margins.
Principal fluctuates with day-to-day changes in interest rates, which are usually small but may swing widely at times. During 2022, these long-term Treasury bonds saw declines that were comparable to the losses on some of the most aggressive equities. Although backed by the full faith and credit of the U.S. government, the price an investor will receive on Treasury bills and bonds that they sell prior to maturity is based on what the current market price is, which may be substantially different from what the investor paid for it or its value at maturity.
Bank Deposits Programs: Exploring the Advantages and Disadvantages
Bank Deposit programs have been around for some time but have recently gained more traction due to an increased interest in FDIC insurance. Traditional bank deposits, such as savings accounts and standard CDs, are a familiar option for individual investors seeking capital preservation. Investors with access to financial services firms such as turnkey asset management programs (TAMPs) can take advantage of economies of scale available in Bank Deposit programs which have the ability to offer ways to increase FDIC insurance through bank diversification while also offering competitive yields and daily liquidity. Bank Deposit programs pool investor money into a vehicle and negotiate rates with participating banks in the program for yields that are more competitive than an individual investor might be able to obtain. Depending on the number of banks in the program, FDIC coverage may range from 2.5 million to 100 million in FDIC insurance which covers a much larger portion of high net-worth individuals.
Pros:
Daily Liquidity: Bank deposit Programs can provide a method of daily liquidity that CDs cannot as they contain early withdrawal penalties, while Bank Deposit Programs generally do not impose withdrawal penalties.
Safety: Bank deposit Programs typically include a number of partner banks that the financial services firms work with. By including a number of banks and administering “pass-through” FDIC insurance, they can effectively cover investors for a much higher amount than the typical $250,000.
Higher Yield Potential: An individual with a $10,000 savings account is not typically able to command an interest rate for that account as high as an individual with $10,000,000 in a savings account. With Bank Deposit Programs, all investors pool their monies into a single entity, allowing them to take advantage of economies of scale with regard to higher deposit rates that banks are willing to pay for those deposits.
Cons:
Unfortunately, while the popularity of Bank Deposit Programs has somewhat increased in light of the SVB banking crisis, few financial services firms that administer these programs have embraced the possibilities. Investors in these are often tiered based on their deposit amounts in such a way that does not allow them to obtain as high a rate as the financial services firm is able to negotiate.
Conclusion
In an inverse yield curve environment, brokered CDs, T Bills, T Bonds, and traditional bank deposits can serve as valuable tools for capital preservation. Brokered CDs offer the potential for higher yields and secondary market liquidity but come with complexities and early withdrawal penalties. Treasuries can be sources of short-term competitive rates, but Treasury bonds may offer some duration risk worth considering. On the other hand, bank deposit programs are simpler and carry lower risk with increased FDIC potential. Financial Advisors should shop around to find bank deposit programs that offer daily liquidity, adequate FDIC coverage, and a competitive rate for each of their clients (both large and small). Financial Advisors need to be wary of their client’s risk tolerance, liquidity needs, and overall financial goals. For those seeking higher yields and are comfortable with potential complexities, brokered CDs or T Bills might be more attractive. Meanwhile, conservative investors, particularly those with smaller balances they want to hold in cash, who prioritize safety and simplicity may find traditional bank deposits a better fit.
Disclosure:
This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax, or investment advice or an investment recommendation, or as a substitute for legal counsel. Any investment products or services named herein are for illustrative purposes only and should not be considered an offer to buy or sell, or an investment recommendation for, any specific security, strategy, or investment product or service. Always consult a qualified professional or your own independent financial professional for personalized advice or investment recommendations tailored to your specific goals, individual situation, and risk tolerance.
Dunham & Associates Investment Counsel, Inc. is a Registered Investment Adviser and Broker/Dealer. Member FINRA/SIPC.
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