For a few months, the short and mid-term applicable federal rates have been on the heels of one another. These rates ride with treasury rates and the economy in general. For some reason, here lately the mid-term rates have been lower on occasion than the short-term rates. I even caught myself thinking, is this a typo? But, digesting a bit of dense economics can actually make some sense of why such is the case. This article intends to help easily illustrate this issue and to make sense of it all by putting the reader in the shoes of an investor who would invest based on this analysis.
As an additional note, I am by no means qualified to give investment advice. The information given in this article is intended to help explain only the inversion of the applicable federal rates and nothing more.
Recently, there have been some significant events in the bond world. I found myself unaware and only tipped off as a result of noticing some peculiarities in the applicable federal rates over the past few months. Aside from generally trending downward, the mid-term rate was less than short-term rate at times.
We will start with a few definitions to describe some of the important terms.
Bond yield – While used interchangeably at times with the term interest rate or coupon rate with respect to bonds, the bond yield is technically the discount rate which results in the cash flows from the bond to equal the bond price. What this means is that if all of the future payments due on the bond were brought back to present value, the rate equal to the bond yield, would cause that present value to equal the purchase price of the bond. Practically speaking, when bond prices go up, yield goes down. When prices go down, yield goes up.
Bond yield curve – The bond yield curve is a graphical representation of the bond yields over time.
Inversion –Inversion is a point of intersection on the bond yield curve of two bonds with different terms of maturity (i.e. 3-month bill vs. 10-year bond).
Applicable Federal Rate – Applicable federal rate (“AFR”) is the minimum interest rate allows for private loans and is set forth in Section 1274(d) of the Internal Revenue Code. The IRS publishes these rates monthly and the rates published consist of short (maturities of 3 years or less), mid (maturities of more than 3 years but not more than 9 years), and long-term rates (maturities more than 9 years). In certain events, when interest is charged in an amount less than the AFR rates, interest income can be imputed for tax purposes or a gift may be deemed to have occurred (though not discussed for the purposes of this article).
In March, the Bond Yield Curve Inverted
Back in March 2019, the bond yield curve inverted. In mid-March, the 10-year Treasury note yield fell below the 3-month Treasury bill. At this point, the 10-year Treasury note was at its lowest point since January 2018. The inverting of the bond yield curve usually signals an impending recession. In recent history, the Treasury bond yield curve inverted before the recessions of 2001, 1991, and 1981. Additionally, the bond yield curve also served as a predictor of the 2008 financial crises, inverting on December 22, 2005.
Time to Recession (Months)
April 11, 1968
|March 9, 1973
|August 18, 1978
September 12, 1980
December 13, 1988
|February 2, 2000
|June 8, 2006
Average time to recession
So, how does this happen?
One commentator believes that this phenomenon occurs as a result of investors seeking shelter in the 10-year Treasury bond, as many investors seem to visualize this asset as a safe bet.1 Since the 10-year bond sets its price by market supply and demand, it can fluctuate based on market responses. Changes in the 10-year Treasury bond can likely be a result of supply-and-demand, more natural market forces caused by changes in investor appetite and temperament.
Things seem to be a bit different with respect to the short-term Treasury bills. The federal government may, as a means to attempt to control the economy, raise or lower the short-term rates. In other words, there may be no good reason for these changes except that the government, acting through the Federal Reserve, thinks it needs to be done, thus these changes are more artificial in nature. Upon collision of these types of events, we can land at an inversion.
Ok, so that is great, makes no sense, and I have no idea what it means…Explain again, simple though.
Investors seeking shelter from market volatility move funds to longer-term bonds, a safer investment. Due to the increased appetite for the longer-term bonds, prices go up. As a result of the increased prices without a corresponding change to the back-end cashflows to the investors from the bond payments, yields go down. At the same time, with investors seeking more sheltered investments, short-term bill demand falls because those investors hope to ride out the storm with a much safer investment for a period of time hopefully longer the expected economic downturn. The government then increases short-term rates to refuel investor appetite for shorter-term and more aggressive investments, thus artificially increasing the yield and resulting in the short-term yields exceeding the longer-term yields (i.e. yield curve inversion).
How does this affect AFR?
Because AFRs are calculated based on bond yields in the markets, an inversion in the bond yields can therefore result in inverted AFR rates (such as mid-term being less than short-term). Since the inversion in March 2019, there has been a coinciding inversion in the AFR Rates (see below).
In May, July, and August, the short-term AFR rate is greater than the mid-term rate. An inversion has occurred, with respect to the AFR rates, as a logical result of the inversion in the bond markets back in March. It is worth noting though that the inversion for the AFR lagged about a month and a half behind the Treasury bonds.
What does this mean?
If anything, my takeaway would be that now, in the downward trending and very low rate environment, people should look to potentially restructure debt and refinance promissory notes. It may prove fruitful to do so as an rate hike by the federal government may occur in the near future. This means that people may be able to revisit or even undertake new estate planning strategies to take advantage of this opportunity to take advantage of low interest rates.2
- See Erik Conley, A Historical Perspective on Inverted Yield Curves, Advisor Perspectives (April 1, 2019), https://www.advisorperspectives.com/articles/2019/04/01/a-historical-perspective-on-inverted-yield-curves.
- See Charles Allen, Interest Rates on the Rise: To Act or Wait (July 27, 2018), https://esapllc.com/interest-rates-rise-act-wait/.