If you were to plot the yields of a one-year, two-year or five-year Treasury issue or an AA-rated municipal security over the course of a particular period of time, you would end up with a yield curve. The top of the curve would represent the high-water-mark yields reached, while the bottom of the curve would depict the lowest the yields reached. In effect, you have a snapshot of how far yields have fallen from their peak levels. The following table offers data concerning the amount of change from the highs of 1985 to the lows reached this year.
Some observations about Treasury yield curves:
If you were to plot the yield curve for the Sept. 25, 1981, issue, you would find that the curve is "inverted," or "negative," because the front end of the curve -- that is, the earlier maturities -- offers more yield than the longer maturities. Historically, yield curves are the opposite -- that is, the longer the period of time you lend money, the higher interest rate you should receive. This type of yield curve is referred to as "positive." A "negative" yield curve arises during a period of high inflation, when the Federal Reserve pushes short-term rates inordinately high in hopes of slowing the economy and, in so doing, curtailing inflation.
Although yields in a negative yield curve offer investors higher returns in the shorter maturities, the ideal place for investors to be before the negative yield curve falls is in the longer maturities. This is so because it enables investors to "lock in" high interest rates for a much longer period of time, and also, as can be seen from the table, when yields fall, price appreciation is greatest in the longer maturities. It should be kept in mind that the Treasury market is the largest fixed-income market of all, with some $1.3 trillion in marketable debt outstanding. It is backed by the federal government, international in scope and, most important, it is used by the Federal Reserve in guiding the nation's monetary policy.
Municipal yield curves, on the other hand, have not declined as much as the Treasury yield curves. It is a much smaller market with approximately $600 billion of issues outstanding with various degrees of credit ratings and some 250,000 different issuers. It attracts specific types of buyers; i.e., banks, fire and casualty insurance companies, corporations and individuals in high tax brackets. Further, the yield curves always remain positive because when a one-year municipal returned 9.25 percent in 1981, for a person in the 50 percent tax bracket, the taxable equivalent would have been 18.5 percent. At the same time, a taxable one-year Treasury returned about 16.25 percent. In other words, the tax-exempt feature is so attractive that the demand will outstrip the supply and help to maintain a positive yield curve. And when tax-exempt yields do move significantly higher, many issuers refrain from issuing. This, in turn, reins in the supply and helps the strong demand maintain a positive yield curve.
Lastly, the decline in the tax-exempt yield curve in 1985 was, on a relative basis, much smaller (13 percent vs. 77 percent) than the Treasury yield curve because the municipal market was faced with an all-time high in volume that overwhelmed the market. This year will be much different because volume will diminish significantly and because of uncertainties regarding the status of tax-exempt issues and the tax brackets of individuals and corporations.
On Wednesday, the Treasury will auction a two-year Treasury note in minimums of $1,000. It should return about 8.25 percent.