Why Go Long When Short-Term Bonds Yield More?

With the Federal Reserve poised to change direction, investors who have been investing in very short-term securities may soon face "reinvestment risk."

Given the shape of the yield curve today, one of the most common questions we receive is, "Why should I buy a longer-term bond with a lower yield when I can get a higher yield with a shorter-term one?"

It may seem counterintuitive, but it can make sense to buy a bond or certificate of deposit (CD) with a lower yield and longer time to maturity vs. a higher-yielding one with a shorter maturity. The reason is that an investor can have greater control over their cash flows, rather than being subject to reinvestment risk—that is, the risk of having to reinvest a maturing security at a lower interest rate in the future. This may be especially worth considering now, when the Federal Reserve appears poised to halt, or at least slow, the series of short-term rate hikes it began in 2022.

A primer on the yield curve

The yield curve is a line that plots yields relative to the length of time they have to maturity. It is a snapshot in time. Yield curves can (and frequently do) shift their shape. The most-tracked yield curve is the Treasury yield curve, but there are many other yield curves—for example, those that capture yields in corporate and municipal bonds and CDs. 

The Treasury yield curve is usually upward-sloping, meaning longer-term securities yield more than shorter-term securities. This makes sense, because investors often demand higher yields for locking their money up for a longer period. However, it's not the case today: The yield curve is currently inverted, meaning shorter-term bonds are yielding more than longer-term bonds. This is largely because the Fed has been pushing short-term rates up for the past year, in an effort to contain inflation.

Treasury yield curve

Chart shows yields on Treasury maturities ranging from three month to 30 years. Yields currently are highest on 1-year Treasuries, then dip sharply.

Source: Bloomberg, Treasury yield curve, as of 3/22/2023

Shorter-term bonds are subject to greater reinvestment risk

All of this leads us to the central question: Why invest in lower-yielding, longer-term bonds when higher-yielding, shorter-term ones are available?

In two words: reinvestment risk. To illustrate how this works, consider an example using one-month and five-year Treasuries in February 2007. (Although this time period was right before the 2007-2008 global financial crisis, we're only using it for illustration purposes; we're not predicting a similar situation.) At that time, both yielded about 5%. However:

  • The investor who purchased one-month Treasury bills would have to repeatedly repurchase a new T-bill each time their Treasury matured, and would therefore invest at the current market rate. 
  • The investor in the five-year Treasury bond would have locked in an annual income of 5% for the subsequent five years. 

Fast forward to the start of 2009, by which time yields on short-term Treasuries had fallen sharply because the Fed aggressively cut rates due to the global financial crisis. The T-bill investor would now be faced with the prospect of rolling over their investment at a rate that is much lower than the original 5%, whereas the five-year Treasury bond investor would continue to earn 5% for another three years.

Chart shows the yield for a 1-month Treasury bill and for a 5-year Treasury bond from 2004 through February 2023.

Source: Bloomberg, as of 2/28/2023, using monthly data.

Past performance is no guarantee of future results

Yields don't move in lockstep

A common misconception is that when the Fed raises the federal funds rate, all yields rise in lockstep. This isn't usually true. As illustrated in the chart below, yields for short-term securities, like a six-month Treasury bill, typically closely track the federal funds rate, whereas longer-term rates are more tied to the outlook for growth and inflation.

The six-month T-bill yield tends to track the federal funds rate, unlike the 10-year Treasury yield

Chart shows the federal fund rate, the six-month Treasury bill yield and the 10-year Treasury bond yield going back to 1990. The T-bill yield historically has closely tracked the federal funds rate, but the 10-year bond yield has not.

Source: Bloomberg, as of 2/28/2023, using monthly data

Past performance is no guarantee of future results.

Going forward, it's likely that the Fed will have to cut interest rates due to slower economic growth and the recent stress in the banking sector. The market now expects that the Fed will cut interest rates sharply later this year. This should cause short-term yields to fall, as well. The implication is that investors who have been investing in very short-term securities may soon face the prospect of lower short-term rates—rates that could even be lower than current long-term rates.

The Fed is expected to cut rates, which should lead to lower yields for short-term securities

Chart shows the path of the federal funds rate and the 3-month Treasury bill yield since the end of 2021, along with market expectations for the federal funds rate as of March 7, 2023, and as of March 23, 2023. Markets now expect the fed funds rate to fall in the second half of 2023.

Source: Bloomberg, as of 3/23/2023

Market estimate of the federal funds rate using Fed Funds Futures Implied Rate. For illustrative purposes only.

Historically, the Fed has paused hiking rates when it believed that the economic growth was about to contract and inflation to slow. In response to the worsening economic background, longer-term Treasuries usually decline. For example, in the past three rate hiking cycles, Treasury yields have fallen six months after the peak in the federal funds rate. 

Average change in various Treasury yields six months after peak fed funds rate

Chart shows the average change in various Treasury yields, from three months to 30 years, six months after the federal funds rate peak during the past three rate-hike cycles.

Source: Bloomberg, as of 3/22/2023

The dates for the peak rate and six months after for each of the three rate-hike cycles are: 12/19/2018 and 6/19/2019, 6/29/2006 and 12/26/2006, and 5/16/2000 and 11/16/2000. Past performance is no guarantee of future results.

While each cycle is unique because the market is forward-looking, in the past once the federal funds rate peaked, longer-term yields fell in anticipation of slowing growth and inflation.

The Treasury yield curve historically has shifted lower after the Fed is done hiking rates

Chart shows how the Treasury yield curve has changed six months after each federal funds rate peak in each of the past three rate hike cycles.

Source: Bloomberg, as of 3/22/2023

Past performance is no guarantee of future results

Total returns may favor intermediate-term bonds going forward

The suggestion to consider longer-term securities relative to shorter-term ones doesn't just apply to investors in individual bonds or CDs. Investors who prefer bond funds, such as mutual funds or exchange-traded funds (ETFs), should take notice, too. Historically, intermediate-term bonds have outperformed shorter-term bonds when the Fed is done hiking interest rates, as illustrated in the chart below. 

For example, in December 2018 the Fed hiked rates for the ninth and final time in that rate-hiking cycle. Over the following 12 months, an index of intermediate-term bonds returned 6.7%, relative to 2.2% for an index of short-term bonds. This is an important point for investors who invest in bond funds rather than individual bonds, because if this pattern holds, intermediate-term bonds may outperform shorter-term ones going forward, since the Fed is likely close to being done hiking rates.

Returns during six months after peak federal funds rate in previous rate-hike cycles

Chart shows the 6-month total return for both short-term and intermediate-term bonds after the month of the peak federal funds rate. Five rate-hike cycles dating back to February 1989 are shown. In all six cases both short- and intermediate-term returns were positive.

Source: Bloomberg, as of 2/28/2023, using monthly data

Six-month total returns for each period are as of month-end. Bloomberg U.S. Aggregate 1-3 Year Total Return Index for "short-term" and Bloomberg U.S. Aggregate 5-7 Year Total Return Index for "intermediate-term." Past performance is no guarantee of future results.

What to do now

We believe that the recent move up in longer-term yields presents an opportunity for investors who have been hesitant to invest in longer-term bonds. We suggest extending duration to lock in those yields. For investors who prefer individual bonds or CDs, two strategies to consider are a ladder or a barbell. Both strategies have the potential benefit of holding some shorter-term bonds while also investing in some longer-term bonds.

For investors who prefer funds, Schwab clients can log in to research individual municipal bonds, view pre-screened municipal bond exchange-traded funds (ETFs) on Schwab's ETF Select List® or municipal bond mutual funds on Schwab's Mutual Fund OneSource Select List®. For additional help in selecting an appropriate solution for your needs, a Schwab Financial Consultant or Fixed Income Specialist can help.