Basic Understanding of Bond Prices and Yields
- Treasury Security:Loan to the US government
- Yield is calculated by expected money back (interest) after loaning said amount
- As demand increases on the bond, the price of the bond increases and thus decreases yield
Yield Curve
- Leading indicator to the market
- Yield % Y Axis, Bond Maturity in X Axis
- Liquidity Premium Theory: Longer term has higher risk because of liquidity (ties up your money for a longer period of time)
- Flat curve = signs of recession: Happens when people have bought so many longer-term bonds that long term bonds is not as attractive as short-term bonds. Investor believes there is greater risk out there that outweighs the risk of longer-term bonds. Example includes expectations that future interest rates to fall or other investments to perform poorly.
Bond Yields and the Stock Market
- Equities on average do fairly well when yields rises
- But when yields are starting with very low levels, and get above a certain threshold (3-4% historically), then it becomes negative to the equities market
- This is because inflation is increasing from elevated levels and there is a correlation to 10-year treasury yield and inflation (10-year treasure yield being forward looking; inflation being backwards looking)
- Higher bond yields will affect the highest leverage stocks with the most debt crushing these companies the most
- If yield goes up, less demand to buy stocks because treasury bonds are considered risk free
- 10 year => over 1.5%, stocks tend sell off
- 5 year => over 0.7%, stocks tend to sell off
- 10-year treasury yield – inflation rate = real interest rate
- 10-year treasury yield = nominal
How does Bond Yields Rise/Fall?
- Stimulus by selling treasury bonds (supply of bonds goes up, price goes down, rates go up)
- Strong growth is coming to economy (less buyers of bonds, leads to higher yields, in return hurts stocks)
- Expectation of inflation to come (no demand for bonds since inflation is higher than bond interest rates, then expected future returns of bonds is negative)
- Expectations that government will raise rates in the future