Bonds are in the news this morning as the US benchmark 10-Year Note hit a level of yield not seen for around sixteen years. However, the Treasury market is something to which most individual investors pay attention to occasionally, if at all, even though it is actually far bigger and more important than the stock market. After all, bonds are traditionally used as the boring part of one’s portfolio, something you buy not for their intrinsic value, but to reduce risk and smooth out the bumps in your account over long periods of time. We hold them because our financial advisors tell us we should, not because we want them.
The relative stability that makes them attractive in that role, however, is exactly what makes them unattractive to most active investors. Making a few percentage points in interest each year, even with the chance of a few more from price appreciation, just isn’t sexy. That is partly why a lot of people do their best to ignore the bond market, but my conversations with investors and traders over the years suggest that in many cases it is also because they don’t really understand bonds at all. They may have some idea that they are reflective of the market’s view of the economic outlook, and some have even got their heads around the idea that higher yields mean lower prices, and that selling drives yields higher, but most don’t really grasp why those things are true or how to apply them to their investing.
So before I can begin to answer the question posed in the headline, let's take a step back and understand bonds more generally.
US Treasuries are seen as a “risk-free” investment, as they are backed by the “full faith and credit” of the United States government. That may seem strange to some people who may have a distrust of the government, but the fact is that they can raise money through taxation of the world’s most prosperous economy and, if all else fails, print cash to repay their debt. Repayment of the amount lent to them by buying their issued bonds is therefore considered to be a certainty.
Treasuries are therefore where institutional investors usually park their cash to get some kind of a return when they believe the economy and/or the stock market are heading for a downturn. Bonds are more popular when things look rough, and less so when the outlook is good.
They are usually quoted in terms of their “yield,” not their price. That yield moves in the opposite direction to price: It goes up when bonds are being sold and down when they are being bought. That confuses a lot of people but is actually quite logical.
The yield of a bond is the annual percentage return that a buyer will get until the bond matures. A bond’s yield is a function of what you pay for it and when it will mature. For practical purposes, it is fair to say that every bond is issued at a face value of $100 for a fixed time period, and investors get $100 back when that time expires. The interest paid to buyers, referred to as the “coupon,” is fixed at the time of issue. So, a 10-Year bond with a 5% coupon will pay the holder $5 per year in interest for 10 years, then pay back the initial $100 investment after that time.
In that case, the annual yield is easy to calculate. It is 5%. That yield, though, wouldn’t look very attractive if interest rates elsewhere were, say, 8%. The 5% coupon is fixed and cannot be changed, but if you pay less than $100 to buy the bond, the real return on that bond, can be adjusted.
Let’s say you buy that $100 face value bond for $80. You will get back $100 after 10 years, remember, so you can add $2 a year profit on that trade in yield to the interest you get. That interest is also higher than 5% if you bought the bond for $80 instead of $100. You still get $5 a year in interest payments, which amounts to 6.25% of your $80 investment.
That, when added to the $2 a year in accrued profits from buying at $80 and selling at $100 ten years later, gives a 10-year return of $70 on your $80 outlay, which amounts to an annual yield of 8.75%. That is why yield and price have an inverse relationship, and the price of bonds adjusts to fit what buyers are demanding in yield on their investment at any given time.
If the government is borrowing a lot of money, as they are now, and the Fed is raising rates to fight inflation, as they also are now, there are two factors pushing bonds down in price: low demand and high underlying interest rates, so the lowest prices and highest yields on the U.S. 10-Year since 2007 are really no surprise.
The question then becomes: Should we all be buying bonds right now?
Well, they are certainly more attractive than they have been in years. Back in 2012, one of my first articles here at Nasdaq.com was partly about risk in bonds. In that piece, I pointed out that something considered risky, such as stock in Micron (MU), was actually a safer bet than Treasuries at that time. Treasury yields were low in historical terms after the recession and couldn’t be expected to be a lot lower for long. That meant that bond prices were high, and yields were low. So low, in fact that inflation, which wasn’t seen as a big problem then, was higher than the anticipated yield. Buying something that had a built in loss over time like that was riskier, I argued than buying a volatile stock like MU at a cyclical low with a disciplined trade structure.
Logically, then, buying bonds at these levels that represent a sixteen year low price is low risk. That, however, doesn’t mean that that trade will be high return. This level of interest rates seems high right now, but that's only because we're comparing it to the last few years. These low rates are the anomaly, and all we have done is to return to normality. A return to those ultra-low rates and high bond prices is far from a sure thing, so buying bonds looking for big price appreciation is not a good idea.
What bonds have done is returned as a viable option for reducing volatility in your portfolio. They are no longer virtually guaranteed to lose value, as they were 11 years ago. While higher interest rates, and therefore lower bind prices, are possible in the short-term, it is hard to see an extended period with rates significantly higher than they are now. So, if, like me, you have got out of the habit of buying and holding bonds over the last decade or so, then yes you should be buying some, if only to reintroduce asset class diversification to your portfolio.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Martin Tillier
Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.
Read Martin's Bio