Rising Treasury yields have mainstream investors in a flap…
For the first time since 2007, the yield on the 10-year Treasury note touched 4.7%.
That’s up from a low of 0.5% in March 2020.
And it’s not just the 10-year yield that’s spiking. You can now earn 5% a year on the 30-year Treasury bond… Or 5.4% on the 1-year Treasury bill.
If you’re tuned into the doomers in the mainstream press, you’ll likely think high yields are a catastrophe for the economy and the stock market.
And that’s not a totally crazy idea…
First, when Treasury yields rise, it pushes up mortgage rates, corporate bond yields, and credit card interest rates. This makes it more expensive to borrow money and spend it.
Second, when investors can earn 5.4% on a 1-year T-bill, with little risk, it incentivizes them to yank money out of stocks and put it into bonds.
But is the doom-and-gloom narrative correct? Or are the folks in the mainstream press missing something important, as usual?
I’ll do my best to answer these questions for you today. First, you must understand the basics of how the bond market works.
Once you do, you’ll be able to decide for yourself what’s going on.
Bonds pay income to investors thanks to their “coupons”…
A “coupon” is the semiannual interest you earn from owning a bond.
Back before the government issued bonds in digital form, you’d get a paper certificate when you bought a bond. Take a look…
Every six months, you’d take a pair of scissors and cut off the coupons at the bottom of the certificate, take it to your bank, and swap it for the dollar amount on the coupon.
Then, when the bond matured, you’d turn in the certificate itself and get the “face value” of the bond back. So, if you paid $1,000 to buy the bond, you’d get $1,000 back.
Different bonds have different coupon rates. These are expressed as a percentage of the bond’s face value. So, if you’ve got a $1,000 Treasury bond with a 5% coupon, you get $50 a year in interest payments.
A bond’s yield is a bit more dynamic…
Like stocks, bonds trade back and forth between investors.
Investor “A” may buy a Treasury bond at face value. But he may sell it to investor “B” for less than that.
This will push up its yield.
Let’s take the Treasury bond from our example above with a face value of $1,000 and a 5% coupon.
If someone buys that bond for $800, and you still collect $50 a year in coupon payments, the yield on that bond for that buyer is now 6.25% (800 / 50 = 6.25%).
And the higher the price of that bond goes, the lower its yield will be.
For instance, if someone buys the same bond for $1,100, the yield is now 4.5% (1,100 / 50 = 4.5%)
That’s why the bond prices and yields move in opposite directions.
The coupon interest doesn’t change. It’s a fixed payout. But a bond’s yield accounts for the price you pay for it above or below its face value.
That’s why bond yields are spiking now…
Bond prices are falling. Fast.
This is where things get interesting.
When the economy looks shaky, investors buy Treasurys because they see them as a safer alternative to stocks. This drives up bond prices and pushes down yields.
When investors feel more confident about the economy, they leave bonds for the potential of higher returns in the stock market.
This causes bond prices to drop and yields to rise.
And that’s what’s happening today. Bond prices are falling because investors are more confident about the economy and are selling their bonds. This is leading to a spike in yields.
This is where the doom-and-gloom narrative goes off the rails.
Higher yields can have negative impacts on stock prices and the economy. But the reason yields are spiking is investor optimism, not investor pessimism.
It’s not hard to see where that optimism is coming from.
Last week, we got news that the U.S. added 336,000 new jobs in September.
That’s nearly double the 170,000 jobs Wall Street was expecting.
Meanwhile, inflation has come down from a high of 9.1% last June to a current reading of 3.7%.
That’s still nearly double the 2% inflation rate the Fed wants to see. But it’s less than half the rate we saw at the peak of the inflation crisis last summer.
And the Atlanta Fed predicts that real GDP growth in the third quarter – in other words, growth over inflation – will come in at 4.9%.
Investors are reacting to this better-than-expected news as they usually do when they become more optimistic…
They’re selling their bonds and buying stocks, as evidenced by the stock market rally at the end of last week.
On Friday, the blue-chip S&P 500 rose 1.2% and the tech-heavy Nasdaq climbed 1.6%.
Remember this the next time you read a scary “bond crash” headline…
Bonds are defensive investments. High bond prices and low bond yields are a sign that investors are hunkered down and avoiding risky stocks.
Low bond prices and higher yields signal investors are growing more optimistic about the economy.
So, instead of panicking about the spike in yields, use them to your advantage.
As I mentioned up top, you can now pick up an annual yield of 5.4% on a 1-year T-bill.
Provided you buy the bond directly and hold it to maturity, that’s about as close to risk-free money as you can get.
Unless the U.S. government defaults on its debt in the meantime – a highly unlikely event – you’ll get what you paid for the bond back after 12 months. Plus, you’ll pick up your 5.4% yield.
After you factor for inflation, that leaves you with a real yield of 1.7% (5.4 – 3.7 = 1.7).
That compares to the dividend yield of just 1.6% you’ll earn by owning a fund that tracks the blue-chip S&P 500.
And this becomes a negative real yield of 2.1% after you factor for inflation (1.6 – 3.7 = -2.1).
So, for income investors, Treasurys are a no-brainer right now.
To learn more or to buy T-bills, you can visit TreasuryDirect.gov.
Regards,
Chris Lowe
Editor, The Daily Cut