Ten Year Treasury 
Note rates are a mood ring for
Worried investors

What do most people mean when they talk about bond rates? The answer isn’t as simple as the rate on a savings account, CD, or fixed annuity. Those instruments have a declared rate of interest, and that interest rate multiplied by your account balance equals the amount of interest your account earns in a year. The interest rate is the instrument’s rate. Easy.

When people discuss bond rates, though, they are referring to Yield To Maturity. The Yield To Maturity, or YTM, is the total return an investor expects to make on a bond purchase, expressed as an annualized rate, if the bond is held to maturity.

There are three factors at play here. Here’s how they work:

1) The purchase price of the bond helps determine the YTM.

New issue bonds are sold at Par, which is $1000. However, bond prices are quoted not in their dollar value, but in a percentage of their dollar value. A bond quoted at 100 is priced at 100% of its Par Value ($1000).

A bond priced at 103 is priced at 103% of its Par Value. This means it is being sold at a premium of $1030. A bond priced at 97 is at 97% of its Par Value and is priced at a discount of $970.

No matter what a bond’s price at purchase it will return its Par Value at maturity. Let’s say someone buys a bond at 97. It will return 100% of its Par Value at maturity. That means you can factor in additional returns on top of the bond interest rate when calculating YTM. The reverse, then, is true for bonds priced at a premium. An investor paying 103 for a bond will “lose” $30, or the 3% premium she paid for the bond, when it matures at Par.

Therefore, part of a bond’s YTM factors in whether it is selling at a premium or a discount. The higher the price, the lower the YTM, and vice versa.

2) YTM also includes the bond’s coupon, or interest, rate.

All else being equal, a bond with a higher coupon rate will have a higher YTM because the bond holder will receive more money in interest payments over the life of the bond. This is the most obvious component of YTM and can be the same as YTM if the bond is trading at Par.

3) YTM also factors in the amount of time until the bond matures.

It’s easiest, at least for me, to think about this in terms of an example.

Imagine you have two bonds, both priced at 97, with a coupon of 3%. Both will return a 3% gain when they mature, and both pay a 3% annual interest.

But if one bond matures in 2 years, and the other matures in 10 years, then the 3% interest earned at maturity is a vastly different percentage of the overall return of the bond.

The investor pays $970 and makes $90 over two years. This is an arithmetic return of 4.63%. YTM is a more complicated calculation than this as it reflects the reinvestment of interest at the current coupon rate (which never happens, by the way). In this case, the actual YTM is 4.60%.

By comparison, the 10 year bond will earn $300 in interest payments over the life of the bond. The investor makes $330 when you include the $30 returned at maturity, but we’re factoring in more years to come up with annualized rate for our YTM number. So, $330 of returns over 10 years from a $970 purchase reflects a YTM of only 3.36%.

All else being equal, the YTM for a 2 year bond will be greater than a YTM for a 10 year bond, because of the impact of time on the value of returns relative to purchase price.

The reason why all of this matters is because bond investors generally are looking for YTM, not just an interest rate, when they buy bonds.

The next question might then be, who are bond investors anyway?

Bond investors are people who want safety.

If the economy appears to be sour, or heading in that direction, investors will start exploring bonds. I write “exploring” because the bonds must have a YTM compelling enough to warrant the risk of potentially missing positive market returns while the money is tied up in the bond.

This means that a bond’s YTM reflects how investors feel about how the economy will grow over the Duration of the bond.

Uh oh, now we have another term to worry about: Duration.

A bond’s Duration is the amount of time it will take an investor to earn back her investment in the bond. Bonds with higher interest payments, and/or priced at a discount at purchase, will return more money to the investor over less time. Such bonds will have a shorter duration than bonds priced at a premium and/or having lower interest rates.

The Duration of a bond, then, is the amount of time that must pass before the investor can exit the investment, break even, and move into another opportunity. The lower the price of the bond, and/or the higher the interest rate, the shorter duration the bond will have.

But back to bond investors…

If a large number of people want to buy 10 Year Treasury Notes, they have a poor view of the economy over a longer period of time relative to people buying short-duration debt instruments like Treasury Bills.

(Notes have maturities of 2, 5, 7, or 10 years).

Remember, the price that investors are willing to pay for something reflects its demand. As with everything else, an increase in demand means an increase in price. As investors flee volatile or contracting markets, the demand for safe instruments will increase. If the scary economic environment is expected to stick around for a while, the price of the 10 Year Note can be expected to rise.

If Note prices are increasing, this now brings into focus the most important thing to understand about how bonds work: bond prices and interest rates are inversely correlated. As interest rates go up, bond prices go down. As interest rates fall, bond prices rise. This means that if a bond’s price is increasing, it’s interest rate will be heading in the opposite direction.

It’s not surprising then, that the YTM on 10 Year Treasury Notes has been falling recently, from a high of around 4.2% in early November, to 3.51% as of the time of this writing.

Another way to interpret this is that the rate on 10 year Notes does not have to be as high because investors are more interested in getting their money out of risky markets than they are in securing a higher yield on that money. Spooked investors need less enticement in the form of higher YTM to be convinced that a 10 Year Note is a better idea right now than, say, an S&P 500 index fund.

This stands in contrast to the interest rates on Treasury Bills, which range in maturity from 4, 8, 13, 17, 26, and 52 weeks. These rates are set by the Federal Reserve and reflect an interest rate that the Fed believes will entice investors to take their money out of capital markets, out of economic circulation, and instead park it somewhere safe.

If short term rates are climbing, as they are now, it means the Fed wants less money circulating the economy. This is why economic pundits are discussing now that the Federal Reserve appears to be trying to engineer a recession.

The negative investor sentiment created by a looming recession is causing investors to demand more 10 year Treasuries, which is driving their YTM down as their price increases. Remember, the higher the price of a bond, the lower the YTM must be.

Based on all of this, we can think of bond rates through the following framework: short term rates tell us the direction the Fed wants to move the economy, while long term rates tell us what investors think about the direction the economy is headed.

Currently, we have two forces at work: the Fed raising short term rates to reduce inflation, and investors paying more for 10 Year Notes (and driving down their yields in the process) because they are spooked by the looming short to medium term economic consequences of the Fed’s actions.

When the Fed wants a recession, and investors are expecting one, you have a recipe for potentially rough economic waters ahead.

Fortunately, it is possible to build durable, resilient investment strategies that may reduce market risk while still allowing you to participate in a recovery.

(What a nice Holiday gift that would be!)

If you would like to learn about how we manage risk for our clients, or get ideas for how you can manage financial risk on your own, we’d love to hear from you.