Since we published the October issue of What Counts, the one- to 10-year advance yield curve continued to flatten, from 237 basis points to 202 basis points. The yield spread between three-month and two-year advances increased from 75 to 85 basis points.

Because of the flattening in the yield curve, the relative “roll-down” benefit in the two-year sector has diminished significantly in recent months. Nevertheless, the two-year sector continues to provide the highest amount of incremental insurance against the potential of rising rates, as compared with longer points on the yield curve.

Consider the following investment alternatives covering a one-year time horizon:

	Purchase a one-year, fixed-income security (assumed to be pegged to the Seattle Bank Advance Curve), in this example, 2.77%.
	Purchase a two-year, fixed-income security, and sell after one year, 3.17% in this example.

In deciding whether to purchase the one-year security, as opposed to purchasing the two-year security and selling it at the end of one-year, an investor should know the answer to a key question: in the event of rising interest rates, even though a modest principal loss would be sustained, would the extra yield earned, relative to one-year portions of the yield curve, more than offset the loss?

Under current market conditions, there are 81 basis points of protection (versus 97 basis points at the time of the October issue), from rising rates over a one-year period, for an investor who opts to purchase a two-year security and sell it at the end of the first year. An investor would have made the right decision, unless rates were to increase by more than 81 basis points during the one-year period.

Since the two-year sector supports the highest point to break-even in the event of a rate rise, this portion of the yield curve would still represent the optimal place to invest at the present time. Conversely, this point would represent the least optimal place on the yield curve to borrow. As such, the eight- to 10-year, or three- to six-month sectors [where there is less curve roll-down (or incremental yield pick-up)] remain the most optimal areas for borrowing.

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