Key Takeaways
- Treasury yields are up again, hitting 3.589% compared to just 0.55% in 2020.
- This might seem like good news, but for existing bondholders it means a huge fall in the prices of their existing Treasuries.
- The inverse relationship between yields and prices has caused bond prices to crash, and it’s likely that they’ve got further to fall.
- Not sure what that means? We explain how that inverse relationship works and what investors can do about it.
After falling consistently since the early 1980s, Treasury yields are rising at the past pace we’ve seen in decades. The 10-year treasury rate has risen from an all-time low of just 0.55% in July 2020, up to 3.589% after a rise on Monday.
So what does this mean in plain english? Treasury yields are essentially the rate of interest earned on US government bonds. They’re considered to be just about the lowest risk investment you can get, because they’re fully backed by the security of the US government.
In investment circles, US Treasury yields are often referred to as the ‘risk free’ rate, because they are as close to zero risk as you can get from an investment point of view.
So to put into perspective, a couple of years ago these bonds were paying basically nothing. Even with inflation down at low, ‘typical’ levels, they were still providing a negative real return. Now, those same bonds are paying yields that don’t actually look half bad.
With that said, with inflation at its current level, the yields are still negative in real terms. That might change in the coming months as rates continue to rise and inflation continues to fall.
While this might all seem like pretty good news for investors looking to buy bonds, it’s not all gravy. In fact, bonds have had some of their worst returns ever, because the price to buy a Treasury moves inversely to its yield.
So if yields go up, prices go down. Confused? Don’t worry, let us explain.
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Why do bond prices go down when yields go up?
Ok so you might have seen this in a news article as a bit of a throwaway line. “Bond prices crash as yields increase” or something similar. On the face of it, this doesn’t make much sense.
After all, in almost any other form of investment, if the yield (income) goes up then the asset price goes up too. If a stock consistently pays a higher dividend yield, generally the price of the stock will rise over time. If the rental income on a property increases, over time the price will as well.
So what’s with bonds then?
Well, it’s all a function of interest rates, plus the fact that these bonds tend to be very long term. So the first thing to keep in mind is that once they’ve been issued, they can be bought and sold between other investors, but they’ll stay in force until the maturity date.
These can be shorter, say around 2 years, it could be 10 years and the longest US Treasuries have a 30 year term.
Now, let’s take a look at an example to help illustrate how the relationship between bond prices and yields work. Say the US government issues a 10 year bond with a yield of 3.5%, which is close to what it is right now.
You buy $1,000 worth of these bonds which will pay you an income of $35 per year.
$1,000 x 3.5% = $35
Say that interest rates go up over the next year and the yield for new 10-Year Treasuries goes up to 5%. Now imagine your friend, let’s call him Gary, wants to buy a 10-Year Treasury bond.
Gary can get a newly issued bond with a 5% yield, meaning that his $1,000 investment would pay him $50 per year. You happen to be looking to sell your bonds, so that you can buy some stocks instead.
If you try to offload your bond to Gary for the amount you paid for it, he’s probably not going to be interested. After all, his $1,000 for your Treasury bond only gets him $35 per year, whereas a newly issued bond will get him $50.
So what do you do? Well, the only way you’re likely to find a buyer for your bond is if you match the yield on offer for new ones. So in this case, you’d have to reduce the purchase price to $700.
That’s because $35/$700 = 5%.
At a price of $700 on the secondary market, your bond now matches the yield of newly issued bonds and the current market price.
With that said, it’s important to keep in mind that this volatility doesn’t impact the fundamental risk of bonds. After all, in this example you could simply hold on to your Treasury for the full 10 years, at which point you’d receive your initial $1,000 back from the US government.
How is this impacting Treasury yields?
Because of this inverse relationship, bond prices have fallen significantly over the past year or so. The Fed has been massively hiking interest rates in a bid to bring down inflation, and this has meant a major increase in yields.
As we’ve seen in the example above, when yields go up, bond prices go down. The faster yields go up, the faster bond prices crash.
Yields have jumped further this week off the back of a better than expected ISM report for November. This report covers a manufacturing index that covers industrial products through metrics such as orders, production levels, employment and inventories.
It can give an indication of the amount of economic activity in the pipeline, prior to the eventual customer sale which is measured through GDP.
Because the report was better than had been projected, yields have increased on the expectation that the Fed will continue their aggressive rate hiking policy. There has been some uncertainty as to how the Fed is planning to approach the upcoming FOMC meeting, with inflation starting to come down but the economy remaining surprisingly resilient.
What’s the outlook for Treasuries?
With all this as the backdrop, what can we expect to happen with US Treasury yields over the next 12 months? Well, Fed chairman Jerome Powell has made it clear that he’s not messing around when it comes to inflation.
The Fed plans to use all of their powers to get it back down to the target range of 2-3%, and this is likely to mean multiple rate hikes from where we are now.
You know what that means now, right? It means interest rates go up further, which means yields go up, which means bond prices go down.
So it’s likely that we’re going to continue to see unusual levels of volatility in the bond market in the short term. On the flip side, once inflation is under control there’s a good chance that the Fed will look to reverse the policy and start to bring rates back down.
This will bring down yields, which would mean an increase in bond prices. Either way, any significant movement in this direction is probably still some time away.
What does this mean for investors?
It means that the traditional 60/40 investment portfolio isn’t really working the way that it should right now. Treasuries and bonds are traditionally seen as a defensive, low volatility asset within a portfolio, and at the moment they’re experiencing higher levels of volatility than normal.
For investors who are looking to keep their volatility down, it may require looking at different options in the short term.
This could mean shifting money over to investment assets that have a better chance of achieving the low volatility aims. One example is our Inflation Protection Kit, which is made up of Treasury Inflation Protected Securities (TIPS), precious metals like gold and silver as well as commodity ETFs and oil futures.
These are assets that are designed to act as a hedge against inflation, and can potentially offer gains without high levels of volatility. We use AI to predict how these assets are likely to perform over the coming week on a risk-adjusted basis, and it then automatically rebalances the portfolio in line with these projections.
For investors who want to maintain a higher growth approach, our AI-powered Portfolio Protection is another great option. This strategy sees our AI analyze your existing portfolio against a range of different risks such as oil risk, interest rate risk and market risk, and it then automatically implements sophisticated hedging strategies to guard against them.
It’s very unique, and it’s available to add on all our Foundation Kits.
Download Q.ai today for access to AI-powered investment strategies.