Playing the spread in today's interest rates

January 10, 2014

| MoneyRates.com Senior Financial Analyst, CFA

Spreads between short-term and long-term interest rates widened in 2013. That creates both opportunities and risks for income-starved investors, and for house-hunting consumers.

At the start of 2013, the difference in yield between a 10-year Treasury and a one-month Treasury was 1.74 percent. By late December that spread had widened to 2.87 percent.

Spreads between long and short-term mortgage rates also increased in 2013, and whether you are looking for income or shopping for mortgage quotes, these changes could impact your strategy.

Income strategy for bonds

Much like savings account rates, short-term bond rates are barely above zero. Though they fluctuated throughout 2013, one-month Treasury yields were at 0.02 percent at the end of 2012, and were at the same level a year later.

For long-term yields, it was a very different story. Ten-year Treasury yields ended 2012 at 1.76 percent, but by late 2013 they had risen to 2.89 percent.

Does that higher yield make long bonds a good place to find income? The answer is yes, with some cautions. Rising interest rates mean that bond prices are falling, and the longer the duration of the bond, the more drastic the price change will be. So, be careful about buying bonds in this environment unless you can hold them until maturity, because otherwise your income yield may be offset by price declines.

Even if you can afford to hold your bonds till maturity, keep in mind that there is a potential opportunity risk of locking into a yield now if rates continue to rise. So, if you are looking for income, this may be a time to start to ease into bonds, but only a little at a time. Keep some powder dry so you can potentially invest more later at even higher yields.

Mortgage choices

On the borrowing side of things, the dynamic is reversed -- higher rates mean greater expense, so widening spreads would favor shorter-term mortgages over long-term ones.

During 2013, the spread between a 30-year and a 15-year mortgage rate widened from 0.70 percent to 0.96 percent. The widening spread between the 30-year rate and a one-year adjustable-rate mortgage (ARM) rate was even more dramatic. This spread grew from 0.77 percent to 1.92 percent.

Just looking at current rates, this would make one-year ARMs much more attractive, but remember, these widening spreads are a function of rising interest rates. Having an ARM when rates are rising puts the homeowner at risk, because mortgage payments could rise to the point where they are no longer affordable. Consider an ARM only if you have the means to pay off your mortgage before the rate has a chance to rise too drastically. Otherwise, look at 15-year fixed rate mortgages as a safer, if less compelling, way of playing the widening spread between long- and short-term rates.

The change in interest rate spreads over the past year is a reminder of just how dynamic interest rates are. These are not markets you can look at once and then assume conditions will stay pretty much the same. Make sure your view of interest rates is up to date when you make any decision involving those rates, so you can improve your chances of playing the spread the right way.

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