Since we published the April issue of What Counts, the one- to 10-year advance yield curve has narrowed to 101 basis points from 112 basis points. The yield spread between three-month and two-year sectors also narrowed to 81 basis points from 95 basis points.

The relative “roll-down” benefit in the two-year sector continued to flatten from 61 to 57 basis points. Nonetheless, the two-year sector continues to provide a slightly higher amount of incremental insurance against the potential of rising rates 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 Seattle Bank advance curve), in this example, 3.78%.
	Purchase a two-year, fixed-income security and sell after one year, in this example, 4.06%.

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 would like to 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 57 basis points of protection (versus 61 basis points one month ago) 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 57 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 still represents 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 8- 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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