As we head into the New Year investors are faced with a strange situation in the bond market: the yield curve is flipping.

Flipping is more commonly known as an inverted yield curve. In such a rare event, the yield on a 10-year government bond is lower than the yield on, say, a 2-year government bond (technically a note). What’s the big deal? Maybe nothing. Maybe something. Maybe a big something. In fact, those most worried about an inverted yield curve fear the implications for the economy and the stock market more than the effect on bond investors.

While bond and stock markets certainly seem erratic (especially in the short run), there are certain relationships between different securities that remain true most of the time. 

Borrowers who have the best chance of paying lenders back can borrow at the lowest interest rates. This is true with ordinary consumers, giant corporate borrowers, or governments. While interest rates fluctuate by the minute, lower quality bonds (tradable loans) always yield more than safe bonds. This is why U.S. Government bonds yield less than even the safest corporate bonds – there is no better lender than someone who can tax the populace to generate money to pay back creditors. GE and IBM can’t do that. Heck, they can’t even raise prices without losing market share.

While higher-risk debt always yields more than safe debt, the gap between the two yields can and does change dramatically. When investors are risk averse, they favor safe debt like government bonds and avoid non-investment grade debt from questionable issuers.

In such an environment, a basket of junk bonds may yield four or five percentage points more than a safe bond. In times of relative calm, investors may require a premium of just a couple percentage points for taking on extra risk. 

The other truism in the debt markets is this: an investor requires a higher yield the longer the term of the loan. Again, this applies to big time pension funds managing billions to a little old lady stopping by the local bank. 

If your bank offers CDs, you’d expect a 5-year CD to pay a higher yield than a 1-year CD, because you are taking on more risk by locking up your money for the longer period. For one, getting your money out can be difficult and costly. Two, interest rates may go up and you locked in at a low rate. Three, the entity you lend money to may be in crummier financial shape in the future. With a 1-year CD you can just buy another one in a year if rates go up. Troubled GM is probably more likely to make the next few payments on their debt than they are to make payments five years from now.

This is why some will scratch their head when they go to the bank today and notice that a 2-year CD is paying roughly what a 5-Year CD pays. As of this writing NetBank is offering a 1-year CD with a 4.59% yield – pretty snazzy for an FDIC-insured investment. Just a few years ago such CDs paid closer to 1%. What’s the payday for a 5-year CD from the same bank? 4.88%. Huh?

Right now the so-called yield curve is very flat, and is becoming inverted by a small amount in certain parts. If recent trends keep up, 1-year rates will be measurably higher than 10-year rates.

So why is this happening, and so what if it is?

Let’s start with the so what: Almost every time in history that the yield curve flipped we’ve had a recession within a couple of years. One exception was 1998, when longer-term rates were below short-term rates. While there were many factors at play eight years ago, at the time there was a brief buying binge in longer-term government bonds as the global economy seemed on the edge of a major debt default caused by the crumbling Russian economy, busted hedge fund LTCM, and the Asian contagion. Things eventually righted themselves and a global crisis was averted. But those were unusual circumstances. Normally an inverted yield curve forecasts a dark future.

As for why, besides a pending global debt crisis, what would make ordinary investors in a semi-robust economy with normal inflation buy a ten-year bond and be happy with less yield than a one-year bond? Why wouldn’t they all buy the shorter-term bonds until the lack of demand sent longer-term yields higher? Why prefer the lower-yield investment, which is technically a higher-risk investment? Would you pay more for the same car without airbags and antilock brakes?

Some experts (notably the incoming Fed Chairman) have offered up a global savings glut as the explanation, noting that countries flush with cash from Saudi Arabia to China are buying up bonds with reckless abandon, owning a full 50% of U.S. Government debt today. Others have postulated that so-called transparency in central banking worldwide makes bond investing safer, so long-term bond buyers require less yield than in the past. 

Sure, but why not buy higher-yielding, short-term investments and roll ‘em over every few years? If short-term rates remained higher than longer-term rates for the next ten years, investors would do better in short-term investments – rolling over 1 and 2-year CDs or buying a short-term bond fund. A glut of dough explains why rates are low in general, not why long-term rates are lower than short-term rates.

The only explanation that seems logical is that investors as a group are pretty darn sure longer-term interest rates are not going up, in fact very likely may fall. 

See, if the 10-year government bond goes from 4.4% back to below 4% in coming years, investors will do quite well owning them. They’d have locked in a 4.4% yield in a 4% world. They could sit back and collect their winnings, or sell the bonds for a quick gain, as they’d be worth more to new buyers. 

If an investor bought the 2-year bond and it falls from 4.4% to 2%, they would quickly find their income stream drying up. They'd be standing there trying to figure out what to do in two years when their bond matures (or CD), faced with either a 2% yield on new short-term bonds, or a sub 4% yield on a 10-year bond. 

This scenario shows the risk of your income falling as rates change, and it can be as dangerous as rising rates to a bond investor. Many “safe” investors in recent years may have noticed this phenomenon if they had most of their money in money market accounts, or if they were rolling over short-term CDs year after year. When the Fed pulled the plug on shorter-term rates back in 2001, such investors, many elderly investors, saw their incomes collapse, while those with longer-term bond portfolios were sitting pretty. The only strange thing is, this is usually not a big fear when rates are already low – most are afraid of rates going up not down.

Therefore, the only explanation for an inverted yield curve is that the majority of investors putting their dollars into the bond market think the return over the next ten years will be higher if they invest in longer-term bonds rather than shorter-term bonds – so much so that shorter-term bonds can pay more than longer-term bonds and still not be attractive.

Another way of looking at this conundrum (to borrow a term from current Fed Chairman Alan Greenspan) is that investors don’t think high short-term rates are going to stick. In the 70s and early 80s this was the case. Rampant inflation and other monetary crises carried short-term rates to around 20%. But nobody really thought the U.S. Government would be in monetary chaos for 30 years so long-term bonds paid under 10%. But we are not in these insane times, and short-term rates are not anywhere near historic highs, or even recent historic averages.

The only likely economic scenario that would call for even lower long-term rates and falling short-term rates is a recession – and one with low inflation. In such a scenario the Federal Reserve would likely reverse course and lower short-term rates once again, in an attempt to re-stimulate the economy.

As for our own portfolios, Bill Gross, who manages the Harbor Bond fund, is calling for a flat yield curve for years to come, and expects shorter-term rates to drop. In his funds he has been buying longer-term bonds – a good idea if the above unfolds. However, we also own shorter-term bond funds in many portfolios that could see lower yields in the future. We expect stocks to be cheaper if a recession strikes, and would likely move the dough to stocks, not keep it all in then-lower yielding bonds. What could be more troubling is if stocks run way up and bond yields fall, because then we’d have the depressing choice of buying overpriced stocks or sticking it out in low-yielding bonds.