Why all shareholders should pay attention to the bond market


In early May, the yield on the US 10-year Treasury note hit 3% for the first time in more than three years. It made headlines around the world, but why does it matter?

Whether you invest in bonds or not, government bond yields are worth looking into. Yields impact everything from mortgage rates to borrowing costs. They can also impact the attractiveness of stocks relative to other investments.

Before we look at why this is important, let’s start with a quick refresher on the basics of obligations.

This article is not personal advice, if you are unsure whether an investment is right for you, seek advice. All investments, including the income from them, can go down as well as up in value, so you could get back less than you invest.

What are government bonds?

In the UK, government bonds are known as gilts. Across the pond in the United States, they’re called treasury bills. It is a loan to the government in exchange for an agreed interest rate based on a predefined “per” value, paid at regular intervals. These payments are known as coupons.

The loan will generally be granted for a fixed term. Once this period is over, a fixed amount of cash, known as the principle, will be returned with the last coupon.

What is the yield?

There are several ways to measure bond performance, some more complex than others. But the one we’re looking at here is current yield. It is calculated by dividing the bond’s annual coupon by its market price.

Here is an example :

Imagine a government bond that pays 5% a year in coupons, with a face value of £1,000. The value of the annual coupons will be 5% of £1,000, or £50. If I buy this bond for £1000, the current yield in this example is simply 5% (50/1000 = 5%).

Once the bond has been issued and trades in the market, its market value may fluctuate. Suppose I buy the bond again a year later for £1,100. The current yield is now 50/1100 = 4.5%.

Example of yield on a 5% bond

It highlights a key relationship in bonds, price and yield move in opposite directions. This means that when one goes up, the other goes down.

I don’t own bonds, so why should I care?

Many shareholders might wonder why it matters that the 10-year US Treasury yield hits 3%.

It comes down to how stocks are valued. One way to value a business is to use the discounted cash flow method. This attempts to calculate the value of a business in today’s money, based on estimates of how much cash it will generate in the future.

The method is based on the principle that the value of £100 in the future is worth less today, as inflation erodes the value of money over time. If you buy £100 worth of groceries today, you won’t be able to get that much if you fast forward ten years and walk to the store with the same £100.

A discount rate is used as part of the calculation to reduce these future cash flows to their present value. The higher the rate, the less they are worth today. This rate is usually based on the yield of 10-year government bonds.

On this basis, rising yields mean that companies whose valuations are based on strong future cash flows (high growth companies) will see their current valuation fall. And the proof is in the pudding, as we have seen this trend come to fruition over the past few months as yields have risen.

Chart showing the performance of 10-year US Treasuries versus US growth stocks

Scroll to see the full table.

Past performance is not indicative of the future. Source: Refinitiv, 05/23/22.

The other impact of higher yields is that they make bonds more attractive to investors. In recent years, yields have bottomed out, meaning investors have been buying riskier investments to seek higher returns. As yields rise, investors tend to shift money from riskier investments like stocks to “safer” government bonds.

What is the yield curve and what does it tell investors?

The yield curve shows the interest rates available on government debt at different maturities. It is used by economists and investors to help gauge the direction of the economy and the sentiment among the markets. It’s certainly not a crystal ball, but it’s a useful tool for understanding and connecting to a broader analysis of investments and the economy.

This is what a normal yield curve looks like.

Example of normal yield curve

Under normal conditions, one would expect the yield of a short-term bond to be lower than that of an equivalent bond with a longer maturity. All things being equal, investors want a better return if they part with their money for a longer period of time. The steeper the curve, the more investors believe the conditions favor riskier investments. This can normally be a sign that economic growth should be strong.

There are times, however, when the yield curve diverges from this baseline, and this is when investors should pay more attention.

Here is the current UK government bond yield curve (GILT).

UK GILT Yield Curve

Source: Bank of England, 19/05/22.

The flatter yield curve we are currently seeing in UK GILTs has always been a signal that a period of slower economic growth may be imminent.

The next stage, which some say indicates a higher risk of recession, is if the curve inverts. This is where longer-dated bonds underperform their shorter-dated counterparts. This was briefly seen in US Treasuries in March and has appeared before every US recession for the past 50 years.

Before we all turn around, there’s an argument that the predictive powers of yield curves have been somewhat muddled in recent years. It comes as central banks pumped money into the system while buying their own bonds in the process, artificially impacting yields.

Nevertheless, paying attention to what is happening in bond markets can help us understand how and why investments in a range of asset classes, such as stocks, perform.

It can also give an overall indication of how markets see economic conditions changing over time. Of course, there is no guarantee that market forecasts are accurate.

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