Bonds and the inverted yield curve
It was significant news. Bloomberg’s Katherine Greifeld, Ruth Carson, and John Ainger, on Thursday wrote that “the yield on the United States 30-year Treasury bonds dropped below 2 per cent for the first time; the world’s pile of negative-yielding debt surpassed $16 trillion; and the yield curve had again inverted”.
So what’s the big deal with US government bonds? What do we mean by negative yield? What difference does it make since aren’t yield and interest rate the same? Aren’t bonds for old people since they don’t pay much, not like stocks — that right now are still roaring? What is meant by a yield curve inversion?
Let’s start at the beginning with a brief overview of individual bond structures based on the perspective of a small investor. Bond mutual funds are not included in this discussion.
Bonds are debt securities issued by governments, municipalities, corporations and other entities. The global bond securities market is massive, more than $100 trillion dollars with $40 trillion attributed alone to the United States.
Bonds are not shares; there is no equity ownership of a company, and certainly, not of a government. On the contrary, an investor in bonds (you are the lender) purchases bonds for various reasons, the three most critical are: safety of principal, liquidity, and interest income.
The credit quality of the bond — in other words “will I get all my money back” — is often more important than the interest rate, particularly for the small investor.
Bonds are categorised by rating agencies from the highest grade, triple A, down to grade D.
A bond rating of C is considered highly speculative, while a D bond, as implied, is in default. Argentina, as an example, has had numerous distress to default bond issues over the years, with the most recent requiring an International Monetary Fund bailout loan.
Thus, high-grade sovereign debt-bonds are greatly desired due to their implied safety. High grade means secure, stable, country governments backing their sovereign bond values such as: the US, UK, Canada, Switzerland, Norway, Germany, Australia, etc.
Bond securities have different maturities from say one to 30 years. Interest rates paid on the face value reflect what investors are willing to pay to buy and hold the bonds. Two-year notes or bonds pay the lowest interest rate (estimated at 1.5 per cent in the current environment), while 30-year bonds the highest (estimated at 3 per cent) because an investor needs an inducement to hold the bond long-term.
Here are the key components of bonds.
• Bonds are primary-issued at a par price, meaning 100 per cent, such as a $1,000 bond with say an attached 3 per cent interest rate coupon and a 30-year maturity. Keep in mind that originally bonds were paper certificates with little $30 coupons attached. Generally, major financial institutions that make a market in bonds purchase most of new bond offerings; then, the bond securities move into the secondary market where they can be bought and sold around the clock.
• A small investor purchases a 30-year bond planning to hold until maturity. Each year the bond buyer will receive $30 interest and at the end of 30 years will receive the par value back, $1,000.
• What happens if the bond buyer purchases two bonds, one at a discount, say $980, which less than par value, and buys the second at a premium, say $1,150, which is more than par value?
The buyer will still only receive $1,000 back at maturity of each bond. Common sense says the first purchase earns a profit of $20 because the bond was cheap, but the second purchase actualises an ultimate loss of $150 at maturity.
There are formulas to calculate types of yields on a bond, depending upon maturity, duration, a call, or a sale interrelated with the coupon interest income received.
Simplistically, the return for an investor’s bond yield is based upon the coupon rate (3 per cent) divided by the bond face value price.
• Estimated yield for bond 1 — 3.06 per cent due to the discount price
• Estimated yield for bond 2 — 2.06 per cent due to the premium paid.
Remember that the investor still only receives $30 interest based upon 3 per cent times the par value of $1,000.
As you can see, bond price face value and interest rates move inversely to each other. If the bond value is discounted below par, the yield will be higher than the coupon rate and conversely, bonds priced at a premium will drive the yield below the coupon rate.
Interest rate sensitivity
Bond prices are highly sensitive to interest rate offerings in capital markets. An investor who purchased a 30-year US Treasury bond paying 4.74 per cent interest, annually (say ten years ago) will find that in the low 2.25 per cent interest rate environment of today, that bond will generally command a high premium price.
Bond yields and prices based upon the above scenarios fluctuate constantly in open markets due to numerous influences: investor demand, credit ratings (high grade, high yield), coupon rate, maturity date, leverage, special features (convertible), geographical areas, political stability, liquidity, safety and more.
What happens to investment strategies when capital markets are in a turmoil, such as tweet barrages, changes in tariff structures, trade agreements, Brexit clarity and many other influences. Will uncertainty trigger a reallocation of securities in a flight to safety?
In the next instalment we will look at how is this all reflected in capital markets.
Sources and links:
• Wikipedia: Bond Market https://en.wikipedia.org/wiki/Bond_market
• Three-part article series on bonds by Martha Harris Myron.
Part 1 — Junk bonds and the tale of the Trump haircut. https://tinyurl.com/y5kp7rkh
Part 2 — Bonds: the good, the bad and the truly junk. https://tinyurl.com/y5q3kt42
Part 3 — Risk and Reward. https://tinyurl.com/y47k7ear
• What does issuing bonds mean? (Victoria Lee Blackstone). https://tinyurl.com/y2ljfcxk
• Bond rally charges on with 30-year Treasury yields below 2 per cent (Katherine Greifeld, Ruth Carson, and John Ainger). https://tinyurl.com/y6o5vkgj
• The yield curve is inverted! Remind me why I care (Brian Chappatta). https://tinyurl.com/y2jmktch
Martha Harris Myron CPA CFP JSM: Masters of Law — international tax and financial services. Dual citizen: Bermudian/US. Pondstraddler Life, financial perspectives for Bermuda islanders and their globally mobile connections on the Great Atlantic Pond. Finance columnist to the Royal Gazette, Bermuda. All proceeds earned from this column go to The Reading Clinic. Contact: email@example.com
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