George S. Chua l February 28, 2024 l Business Mirror
YIELD curves are a graphic representation of interest rates for different maturity tenors.
Essentially, under normal circumstances, the rational expectation is that interest rates will be higher as the maturity tenor becomes longer. Meaning that placements for 1 year will get a higher interest rate than a one-month deposit.
Similarly, if you were on the borrowing side, a fixed rate loan for 5 years will also be higher than a similar 5 year loan where there is a variable interest rate, where the interest rate is adjusted annually. Due to the higher risks involved in longer term maturities and fixed interest rates for longer periods, both investors and lenders would demand a yield premium for this higher liquidity and rate risks.
This is referred to as a “Normal” or “Positive” yield curve. The opposite of this is known as an “Inverted” or “Negative” yield curve.
An inverted yield curve is when rates are higher for shorter term instruments than longer term papers. This happens when there is a temporary situation in the interest markets such as monetary tightness or a regulatory market intervention similar to what the Federal Reserve System is doing to increase interest rates.
There are two viewpoints on interest rates. On one hand, the Borrower would like to see the interest rates that they are borrowing at the lowest possible levels so that they will pay the least amount. On the other hand, the Investors would like to see interest rates at the highest levels so they end up with a higher yield.
To complicate matters a bit, you should also understand that fixed interest rates can be good or bad depending on which side of the fence you are on. For example, you got a mortgage on your house with a 30 year fixed interest of 7.32 percent. You might think you made a mistake if the current short term rate is 5.5 percent, however, 30 years is a long time and in a few years the rate moves up to 10 percent then you are probably doing fine.
As an investor, we invest in papers of blue chip companies to minimize our credit risk, what we fail to take into account is the interest rate risk. If you invested in a 10-year blue chip bond, that had a coupon rate of 5 percent, you could still lose money if new issuances by the same company are already giving a coupon rate of 7 percent.
Why? On the secondary market, no one will buy your bond at 100 percent face value since the yield is only 5 percent. Investors are expecting a yield of 7 percent and will demand for a discount on the face value so that they will get a 7 percent yield.
The only way to get out of this predicament is if you wait until maturity to have your bond redeemed at face value, assuming it has a maturity date, since many bonds now are perpetual, meaning they have no expiry date.
My suggestion is that during times of uncertainty and volatility, keep your investments more liquid by placing your money in short term instruments. Only when you see clarity in the markets that interest rates are moving down, should you consider locking in at a higher interest rate.
*** The views and comments of Dr. George S. Chua are his own and not of the BusinessMirror or the Financial Executives Institute of the Philippines (Finex). The author was 2016 Finex President, 2010 to 2020 FPI President, an active Entrepreneur in fintech, broadcast, media, telecommunications, properties and a regular member of the National Press Club. Chua is also a Professorial Lecturer 2 at the University of the Philippines’s Diliman and BGC campuses, vice chairman and governor of the Market Governance Board of the PDEx (Philippine Dealing & Exchange Corp.) and a trustee of the Finex Foundation. Comments may be sent to georgechuaph@yahoo.com or gschua@up.edu.ph.)