Anybody who watches the financial channels on T.V. or follows the markets in any way is now aware that rising bond yields, and in particular the yield of the 10-Year Treasury Note, are the big story right now. Over the last couple of days, we have moved above a 3% yield on the 10-Year and then retraced back under the level a couple of times.
Each time, stocks have dropped on the break and then climbed back when we drop back below it, so most are aware that that level is significant. I am sure, however, that there are many people who don’t really know what a yield is, how it is calculated, or why they matter.
Put simply, yield is the annual return an investor will get on their investment should they buy a bond at the prevailing price. Once you make that purchase, your interest return is fixed in dollar terms, even though the price of the underlying bond may vary. To understand why that, is you must understand the relationship between the price of a bond and its yield.
Bonds are essentially loans, and when issued, they have two main components that decide their price: face value and coupon.
- The face value is the nominal price of the bond at issuance, and what the issuer promises to repay at the end of the bond’s life, a time known as maturity.
- The coupon is the percentage of that face value that will be paid in interest each year.
Thus a $100 face value bond with a 5% coupon will pay to the holder a fixed $5 every year.
Whether that 5% return is a good deal for an investor or not depends on what return they could get for their money elsewhere. If the prevailing market interest rate is 7%, then locking in a 5% return for the life of the bond obviously makes no sense.
Where the yield comes in play
If you buy that bond for less than $100 (which can be done in the secondary market), then the $5 payments represent a higher percentage return on your money. In addition, even if you only paid $90 for that bond, at maturity you will still receive $100.
If you add together the 5.5% that $5 annual interest on a $90 investment represents, and the 1.1% annual return gained by buying the bond at $90 then redeeming it at $100 ten years later, you get a total return, or yield of 6.6%.
It is actually not quite that simple (there are many other factors at play), but you get the gist.
That total return is what matters to traders and investors, so the state of the bond and Treasury markets is expressed in yield. What controls that yield though, is what price is paid for the bond.
Why does it matter so much to stocks?
So, now you understand what a yield is and how and why it moves, the next question to address is why does the yield on the 10-Year Treasury matter so much to stocks? Treasuries are bonds issued by the U.S. government, and are considered among the safest investment is the world.
The yield that investors demand on them is therefore the benchmark off which other borrowing is set. So, when Treasury yields climb, the cost of borrowing of all kinds, from business loans to personal credit cards, goes up too. In an expanding economy, borrowing is an essential component of growth and higher rates discourage borrowing, making a jump in rates a threat to future growth.
There is really nothing magical about the 3% level for yields on the 10-Year, but it is psychologically important. Trading consistently above that level suggests that Treasury yields will settle into a new, higher range and that that could easily choke of the growth that we have seen for the last nine years. That is why, even as companies report stellar earnings, stocks come under pressure when yields rise.
The current news cycle has brought Treasury yields to the attention of many people, but whether they are the stuff of headlines or not, they are closely followed by traders in every market. Whether they are trading stocks, commodities, forex or anything else, Treasury yields matter to and are understood by traders of all stripes. They should matter to and be understood by you too.