The central theses
- Government bond yields have risen again, hitting 3.589%, compared to just 0.55% in 2020.
- This may seem like good news, but for existing bondholders, it means a huge drop in the prices of their existing government bonds.
- The inverse relationship between yields and prices has caused bond prices to plummet, and they are likely to fall further.
- Not sure what that means? We explain how this inverse relationship works and what investors can do about it.
After falling steadily since the early 1980s, US Treasury yields are rising at the pace we’ve seen in decades. The 10-year Treasury rate has risen to 3.589% from an all-time low of just 0.55% in July 2020 after rising on Monday.
What does that mean in plain language? Treasury yields are essentially the interest rates earned on US Treasury bonds. They are considered to be the least risky investment you can get as they are fully backed by US government security.
In investment circles, US Treasury bond yields are often referred to as the “risk-free” rate because they are as close to zero as is possible from an investment perspective.
To put it in perspective, a few years ago these bonds were practically non-paying. Even when inflation had fallen to low, ‘typical’ levels, they still delivered a negative real return. Now those same bonds are paying yields that don’t actually look that bad.
That said, with inflation at current levels, yields are still negative in real terms. That could change in the coming months as interest rates continue to rise and inflation continues to fall.
While this may all seem like pretty good news to investors looking to buy bonds, it’s not all. In fact, because the price of buying a government bond moves inversely with its yield, bonds have had some of their worst returns ever.
So when yields rise, prices fall. Confused? Don’t worry, let us explain.
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Why do bond prices fall when yields rise?
Ok, you may have seen this in a news article as a throwaway line of sorts. “Bond prices plummet when yields rise” or something like that. At first glance, this makes little sense.
Because with almost every other form of investment, the asset price increases when the return (income) increases. Generally, if a stock consistently pays a higher dividend yield, the price of the stock will increase over time. If the rental income from a property increases, the price will also increase over time.
Then what about bonds?
Well, it’s all a function of interest rates and the fact that these bonds tend to be very long-term. So, the first thing to note is that they can be bought and sold between other investors once they are issued, but remain in force until the maturity date.
These can be shorter, say around 2 years, they could be 10 years and the longest US Treasuries have a maturity of 30 years.
Now let’s look at an example to illustrate how the relationship between bond prices and yields works. Let’s say the US government issues a 10-year bond at a yield of 3.5%, which is roughly where it is today.
You buy these $1,000 worth of bonds, earning you $35 a year in income.
$1,000 x 3.5% = $35
Suppose interest rates rise over the next year and the yield on new 10-year government bonds rises to 5%. Now imagine your friend, let’s call him Gary, wants to buy a 10-year government bond.
Gary can get a newly issued bond with a 5% yield, which means his $1,000 investment would earn him $50 per year. You happen to want to sell your bonds to buy stocks instead.
If you try to give Gary your deposit for the amount you paid for it, chances are he won’t be interested. After all, his $1,000 on your Treasury bond will only make him $35 a year, while a newly issued bond will make him $50.
So what are you doing? Well, the only way you’re likely to find a buyer for your bond is to match the offered yield on new bonds. In this case, you would have to reduce the purchase price to $700.
That’s because $35/$700 = 5%.
At $700 in the secondary market, your bond now equals the yield on newly issued bonds and the current market price.
With this in mind, it is important to remember that this volatility does not affect the fundamental risk of bonds. Finally, in this example, you could just keep your treasury for the full 10 years and then get your initial $1,000 back from the US government.
How is this affecting Treasury returns?
Because of this inverse relationship, bond prices have fallen significantly over the past year or so. The Fed has raised interest rates sharply to bring down inflation, and this has caused yields to rise significantly.
As we saw in the example above, when yields rise, bond prices fall. The faster yields rise, the faster bond prices plummet.
Yields continued to rise this week on a better than expected November ISM report. This report includes a manufacturing index that covers manufactured products by metrics such as orders, production levels, employment, and inventories.
It can give an indication of the level of economic activity in the pipeline ahead of the eventual customer sale, which is measured by GDP.
With the report coming in better than forecast, yields have risen on expectations that the Fed will continue its aggressive rate hike policy. There was some uncertainty about how the Fed plans to address the upcoming FOMC meeting as inflation is beginning to ease but the economy remains surprisingly resilient.
What is the outlook for Treasuries?
With this in mind, what can we expect for US Treasury yields over the next 12 months? Well, Fed Chair Jerome Powell has made it clear that he’s not playing around on inflation.
The Fed plans to use all its power to bring it back down to the 2-3% target range and that will likely mean several rate hikes from where we are now.
You know what that means now, don’t you? It means interest rates keep going up, which means yields go up, which means bond prices go down.
So it is likely that we will continue to see unusual levels of volatility in the bond market in the near term. On the other hand, there’s a good chance the Fed will try to reverse policy and cut rates again once inflation is under control.
This will lower yields, which would mean bond prices rise. In any case, any significant move in that direction is likely some time away.
What does this mean for investors?
That means the traditional 60/40 investment portfolio isn’t really performing as it should right now. Traditionally viewed as a low volatility defensive investment within a portfolio, government bonds and bonds are currently subject to higher than normal volatility.
For investors looking to keep their volatility low, there may be a need to consider different options in the short term.
This could mean reallocating money into assets that have a better chance of meeting low volatility goals. An example is our Inflation Protection Kit, which consists of Treasury Inflation Protected Securities (TIPS), precious metals such as gold and silver, and commodity ETFs and oil futures.
These are assets designed to act as a hedge against inflation and can potentially offer gains without high volatility. We use AI to predict how these assets are likely to perform over the coming week on a risk-adjusted basis, and then automatically rebalance the portfolio according to those forecasts.
For investors looking to maintain a higher growth approach, our AI-powered portfolio protection is another great option. With this strategy, our AI analyzes your existing portfolio against a range of different risks such as oil risk, interest rate risk and market risk, and then automatically implements sophisticated hedging strategies to protect against them.
It is very unique and can be added to any of our Foundation Kits.
Download Q.ai today for access to AI-supported investment strategies.