The following is from the Annual Report for 2007 for the Vanguard 500 Index Fund: The Federal Reserve Board extended its money-tightening campaign during the first half of the year, raising its target for the federal funds rate four times.
The Fed then paused, leaving the target rate unchanged at 5.25% for the rest of the year and inflation fears eased. Bond yields declined in the second half of the year, and short term yields were higher than longer-term yields.
a. What do economists call the situation in which short-term yields are higher than long-term yields?
b. Long-term bonds are exposed to greater interest-rate risk and have lower liquidity than short-term bonds. Why, then, would any investor buy long-term bonds if their yields are lower than those of short-term bonds?