by Zain Jaffer
Many investors carefully track the ten year US treasury bond yields (or rates) for many reasons. The US needs money to fund its expenditures, and if revenues from taxes and other sources is not enough, it needs to borrow money. The way it does that is to sell short term bills and longer term bonds, which are basically IOUs with differing promises of annual yields. So when you buy a bond, you are loaning the government money at the yield rate when you bought it.
Generally speaking, government bonds are safer than investing in “on-risk” assets like stocks and crypto. Most investors in the past few years tended towards equities and crypto, but as bond yields begin to rise, they slowly start to favor these fixed interest instruments because of the low risk.
As of mid October 2023, the US National Debt Clock [see https://www.usdebtclock.org/] stated that America currently had a debt of around $33.5T, and the ratio of what it makes in terms of GDP to its debt was around 1.24%. In the immediate term, we may not immediately see some negative impacts, but long term we can see bond buyers taper off and lose interest in buying our bonds if our debt continues to far outpace our GDP.
For now, the argument that holding bonds up to maturity is relatively safe is true. Unfortunately however, if like some domestic banks, the bondholder is not able to hold on to the bond up to maturity, something called duration risk could affect them. Basically if newer bond yields go up, the older bonds are worth less if sold prior to maturity. These paper asset value losses are marked to current market value in the balance sheets.
There’s also credit risk, where the bond issuer cannot pay both the interest and the actual principal. But since we are talking about US government bonds, let us not go there and contemplate the remote but unthinkable possibility.
A dynamic we need to consider is that bond prices and yields move in opposite directions. When bonds fail to attract buyers, the government generally raises the yields. This lowers the price of current bonds, as who wants to hold a lower yielding long term bond when a higher yielding one is available. Conversely, when bonds are attractive and there are many buyers, the government can offer lower yields. This is because if there are many buyers, the government does not want to overpay for interest. The government will only offer higher yields if they are having a hard time borrowing from the market because the bonds do not sell.
This is a real problem. At the moment, according to the US National Debt Clock, interest payments moving forward may become the largest component that needs to be paid, becoming even larger than defense, Medicare, and Social Security.
Ten Year Treasury Bond Yields
The ten year US Treasury bond yield is used as a proxy for many other important financial rates, such as mortgage rates.
When the yields of these long term treasuries are high, companies and projects seeking financing for their projects will have to show a higher hurdle rate. The hurdle rate is their minimum rate of return for the investor. If a risk free bond is yielding 5% for ten years, why would an investor take a risk on something, maybe a real estate project, that yields just 2% above that?
U.S Treasuries are often sold via auction. The yields are set through a bidding process. When economic confidence is high, there is less demand for long term fixed interest instruments, and investors prefer equities. Since the Government wants to sell these bonds, higher yields are offered to entice buyers.
During times of low economic confidence, investors leave equities and move towards fixed interest instruments like bonds. Bond prices rise, and the Government can offer lower yields. Basically falling yields indicate caution in the markets.
Also relevant to the yield is the time to maturity. Typically for longer term bonds that are for several years, even decades, investors want higher yields for their risk. However, as we encountered in recent months, if the short term outlook is bleak, the short term yields rise and a “yield curve inversion” occurs.
Investors and economists often compare the historical yields of the ten year bond, and make decisions about the future moving forward. It can be affected by the fiscal deficit or surplus situation of the US government, wars abroad, and other geopolitical and local factors.
Inflation is an important factor to consider. If you are holding an old Treasury bond that yields less than current inflation rates, then you are already losing money.
For most companies and investors, having a fixed interest instrument like a ten year bond probably helps them sleep better at night. Unfortunately in certain economic and political conditions, it can also be outpaced by inflation and changes in interest rates.
SOURCES
https://www.investopedia.com/articles/investing/100814/why-10-year-us-treasury-rates-matter.asp