Category Archives: Bonds

Stocks Beat Bonds as Inflation Hedge

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“Stocks are great long-term inflation hedges if you are still worried about inflationary risks.” ~ Jeremy Siegel, Wharton School Economist

“If you are worried about the inflationary impacts, stocks are far better hedges than bonds — as companies can pass along their own input cost spikes to consumers,”Jeremy Siegel, Wharton School Economist, wrote in his weekly commentary published Monday for WisdomTree, where he is senior economist.

“If you bought the inflation-hedged bonds at 2% yields, it would take 36 years to double your purchasing power,” wrote Siegel, an emeritus professor at The Wharton School. “The S&P 500, however, is priced around 18 times next year’s earnings, giving a 5.5% earnings yield. This takes just 13 years to double purchasing power.”

“Stocks at the present time—with earnings of just under $250 for the S&P 500,” are preferred states Siegel. “This giving just under an 18x earnings per share valued market. I think that is a favorable multiple for the market. I believe stocks are great long-term inflation hedges if you are still worried about inflationary risks. I think stocks can handle another quarter point rise by the Fed if they deem it necessary.”

References:

  1. https://www.thinkadvisor.com/2023/09/28/jeremy-siegel-stocks-beating-bonds-as-inflation-hedge/
  2. https://www.wisdomtree.eu/-/media/us-media-files/documents/resource-library/weekly-commentary/siegel-weekly-commentary.pdf

Inverted Yield Curve and the U.S. Treasury 10 Year

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Given the inverted yield curve and its correlation to predicting recessions, the risk of recession is still elevated, explains Collin. The yield curve is inverted when long-term treasury yields fall below short-term treasury yields.

For example, the 10-year treasury yield is about 3-1/2% %, but the two-year treasury yield is about 4%. And the yield curve tends to invert once the markets begin pricing in Fed rate cuts and tends to send long-term yields lower. Long-term yields like that 10-year treasury yield are often based on Fed Funds Rate expectations over the next 10 years or so. So if the Fed Funds Rate is 5% like it is today, but the Fed Funds Rate is expected to be lower in a year or two, you’ll tend to see longer term yields decline to sort of average out what the Fed Funds Rate might be over the next number of years.

An inverted yield curve is usually followed by a recession. When the Fed hikes rates, it often slows growth along with inflation. It doesn’t necessarily just bring inflation down. When the Fed hikes rates, things in the economy and financial markets tend to break. Maybe the economy slows, maybe corporate defaults pick up, but any way you slice it, there can be negative consequences from Fed rate hikes. So when things break, the Fed then tends to cut rates to stimulate the economy, which can un-invert the yield curve. For example, short-term Treasury bills or treasury notes could fall if and when the Fed cuts rates and they tend to fall below that level of long-term yields.

Now, we think that’s what’s led to the yield curve being less inverted now, it’s really just due to expectations of sooner than expected rate cuts, so short-term rates have fallen more than long-term yields have declined. But if an inverted yield curve is usually followed by a recession, that doesn’t mean that the fact that the yield curve is becoming less inverted is sending a positive signal about the economy.

Just the presence of rate cut expectations tells us that the likelihood of a recession is on the rise, mainly because the Fed cuts rates when they need to, when they need to stimulate the economy. And we think, unfortunately, the Fed will tighten enough right now, not just to slow inflation, but they’ll likely weaken the labor market, which can lead to slower consumer spending, and then the risk of recession is still there.

References:

 

Bond Market Volatility

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A bond is a loan made to a corporation or government in exchange for regular interest payments. The bond issuer agrees to pay back the loan by a specific date. Bonds can be traded on the secondary market. The bond market is usually where investors venture when looking for stability, security, and a lower risk profile as a part of their investment portfolio.

What happens in the bond market has real implications for equity investors and for the economy in general. A bond essentially represents an IOU—a promise to repay a loan on a certain date, along with specified interest payments along the way.

Prices and interest rates for an individual bond depend on a variety of factors, including positive or negative news about the issuer or changes in its credit rating.

But at a higher level, returns in the bond markets are much more related to interest rate changes—and perceptions about what will happen to interest rates in the future. When interest rates fall, the prices of existing bonds go up. And when interest rates rise, the opposite happens: If your loan is earning you less money than someone could make by giving a brand-new loan, they’re going to pay less to buy your loan. This creates volatility in the bond market.

However, the volatility seen in the bond market in the recent short term hasn’t been seen in decades.

Volatility has returned to the bond sector. And, some of the “rules” that have held true in the bond market for decades have been overturned. For example, early last month in March 2023, the year U.S. Treasury bond yield briefly ticked above 5%, which is the highest it had been in more than 15 years. A couple of weeks later it was back below 4%.

In early March, Fed Chair Jerome Powell stated in testimony before Congress that the peak Fed Funds Rate was likely to be higher than many initially expected, explains Collin Martin, director and fixed income strategist, Schwab Center for Financial Research. And when Powell suggested that, investors began to act, and they sent up treasury yields to where they expected the Fed Funds Rate to reach down the road. Now, like most investments, yield comes down to supply and demand. And following the comments from Powell, treasury investors demanded higher yields then, in the short term, so that they weren’t stuck holding investments with lower yields if the Fed did hike more than they initially anticipated.

The dynamics changed pretty suddenly with the collapse of Silicon Valley Bank pulling down yields sharply, because of concerns about financial stability, Collin stated.

Now, the Fed has a dual mandate of price stability, which can be considered inflation, and maximum employment. But the Fed also has an unofficial mandate of financial stability, and the collapse and failure of a few banks led to concern that stability could deteriorate.

So investors totally shifted their expectations for Fed policy, and instead of expecting a peak rate of 5-1/2% or more, expectations were that the peak rate might only be 5% or so. In fact, bpnd investors weren’t even sure if the Fed would hike at all going forward, and they began to price in rate cuts sooner than expected. Now, if the Fed was only expected to hold its rate at 5% or so, and then cut it soon, investors pulled down those expectations and were willing to accept a lower yield and lock in that lower yield for certainty rather than risk what happens if the Fed cuts rates down the road. And that’s what pulled their prices up and yields down because of those expectations.

References:

  1. Volatile Bond Market Signaling Changes to Economy podcast transcript, Charles Schwab WashingtonWise, April 6, 2023.
  2. https://investor.vanguard.com/investor-resources-education/portfolio-management/bond-markets#modal-bond

Types of Bonds

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Bonds can play a vital role in your investment or retirement portfolio. Bonds yield income, are often considered less risky than stocks and can help diversify your portfolio.  ~ BlackRock

Bonds – also known as fixed income instruments – are used by governments or companies to raise capital by borrowing from investors. Bonds are typically issued to raise funds for specific projects. In return, the bond issuer promises to pay back the investment, with interest, over a certain period of time.

Certain types of bonds – corporate and government bonds – are rated by credit agencies to help determine the quality of those bonds. These ratings are used to help assess the likelihood that investors will be repaid. Typically, bond ratings are grouped into two major categories: investment grade (higher rated) and high yield (lower rated).

The three major types of bonds are corporate, municipal, and Treasury bonds:

  • Corporate bonds are debt instruments issued by a company to raise capital for initiatives like expansion, research and development. The interest you earn from corporate bonds is taxable. But corporate bonds usually offer higher yields than government or municipal bonds to offset this disadvantage.
  • Municipal bonds are issued by a city, town or state to raise money for public projects such as schools, roads and hospitals. Unlike corporate bonds, the interest you earn from municipal bonds is tax-free. There are two types of municipal bonds: general obligation and revenue.
    • Municipalities use general obligation bonds to fund projects that don’t produce income, such as playgrounds and parks. Because general obligation bonds are backed by the full faith and credit of the issuing municipality, the issuer can take whatever measures necessary to guarantee payments on the bonds, such as raising taxes. 
    • Revenue bonds, on the other hand, pay back investors with the income they’re expected to create. For example, if a state issues revenue bonds to finance a new highway, it would use the funds generated by tolls to pay bondholders. Both general obligation and revenue bonds are exempt from federal taxes, and local municipal bonds are often exempt from state and local taxes as well. Revenue bonds a good way to invest in a community while generating interest.
  • Treasury bonds (also known as T-bonds) are issued by the U.S. government. Since they’re backed by the full faith and credit of the U.S. government, treasury bonds are considered risk-free. But treasury bonds don’t yield interest rates as high as corporate bonds. While treasury bonds are subject to federal tax, they’re exempt from state and local taxes.
  • Bond funds are mutual funds that typically invest in a variety of bonds, such as corporate, municipal, Treasury, or junk bonds. Bond funds usually pay higher interest rates than bank accounts, money market accounts or certificates of deposit. For a low investment minimum ranging from a few hundred to a few thousand dollars, bond funds allow you to invest in a whole range of bonds, managed by professional money managers. When investing in bond funds, keep in mind:Bond funds usually include higher management fees and commissions
  • Junk bonds are a type of high-yield corporate bond that are rated below investment grade. While these bonds offer higher yields, junk bonds are named because of their higher default risk compared to investment grade bonds. Investors with a lower tolerance for risk may want to avoid investing in junk bonds.

Bonds are an investment approach focused on preservation of capital and the generation of income. It typically includes investments like government and corporate bonds. Fixed income can, such as bonds, offer a steady stream of income with less risk than stocks.

References:

  1. https://www.blackrock.com/us/individual/education/how-to-invest-in-bonds

Duration Risk…What Does It Mean

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Duration is a measure of the sensitivity of the price of a bond to a change in interest rates.  Interest rate changes can affect the value of a bank or financial institution’s fixed income (bond) holdings. How a bond or bond portfolio’s value is likely to be impacted by rising or falling interest rates is best measured by duration.  ~ PIMCO

Duration is a measurement of a bond’s interest rate risk that considers a bond’s maturity, yield, coupon and call features. These many factors are calculated into one number that measures how sensitive a bond’s value may be to interest rate changes.

Interest rates may change after you invest in a bond and interest rate changes have a significant impact on bond values. Say you invest in a bond at 5% interest. If interest rates increase by 1%, additional investors in the same bond will now demand a 6% rate of return. Because the bond interest payments are fixed each year, the market price of the bond will decrease to increase the rate of return from 5% to 6%.

The key point to understanding how interest rates and bond prices are related.  It’s important to remember that interest rates and bond prices move in opposite directions. When interest rates rise, prices of traditional bonds fall, and vice versa. So if you own a bond that is paying a 3% interest rate (in other words, yielding 3%) and rates rise, that 3% yield doesn’t look as attractive. It’s lost some appeal (and value) in the marketplace.

Duration is measured in years. Generally, the higher the duration of a bond or a bond fund (meaning the longer you need to wait for the payment of coupons and return of principal), the more its price will drop as interest rates rise.

Duration risk, also known as interest rate risk, is the possibility that changes in borrowing rates (i.e. interest rates) or the Federal Reserve fund rate may reduce or increase the market value of a fixed-income investment.

Generally, the higher a bond’s duration, the more its value will fall as interest rates rise, because when rates go up, bond values fall and vice versa.

If an investor expects interest rates to fall during the course of the time the bond is held, a bond with a longer duration would be appealing because the bond’s value would increase more than comparable bonds with shorter durations.

As you might conclude, the shorter a bond’s duration, the less volatile it is likely to be. For example, a bond with a one-year duration would only lose 1% in value if rates were to rise by 1%. In contrast, a bond with a duration of 10 years would lose 10% if rates were to rise by that same 1%. Conversely, if rates fell by 1%, bonds with a longer duration would gain more while those with a shorter duration would gain less.

% Change in bond prices if rates spike 1%
Hypothetical illustration of the effects of duration, exclusively on bond prices

In summary, bond duration measures the interest rate risk. It is a measure of the change in bond prices due to a change in interest rate. Duration is measured in years. The higher the duration of the bond, the more will be the price drop as interest rates increase. This is because one needs to wait longer to get their coupon payments and principal amount back.

Bond duration is important as it helps in measuring the sensitivity of a bond’s price to interest rates. If the interest rates were to fall by 1% and bond duration is three years, then the price will increase by 3%. This knowledge will help you understand the effect on interest rate changes on the portfolio returns.

References:

  1. https://www.pimco.co.uk/en-gb/resources/education/understanding-duration 
  2. https://scripbox.com/mf/bond-duration/https://scripbox.com/mf/bond-duration/
  3. https://www.blackrock.com/us/individual/education/understanding-duration

This 10-year Treasury Yield

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The 10-year Treasury yield is closely watched as an indicator of broader investor confidence.

The U.S. Treasury 10-year note yield signals investor confidence in the overall economy and markets. Investors pay keen attention to movements in 10-year Treasury yields because they serve as a benchmark for other borrowing rates, such as mortgage rates. When the 10-year yield fluctuates, it can have significant implications across the financial landscape, according to Forbes.

The U.S. Treasury issues 10-year T-notes at a face value of $1,000, and a coupon specifying a certain amount of interest to be paid every six months. The notes are sold through auctions conducted by the Federal Reserve and yields are set through a bidding process. The notes can be resold to other investors in the secondary market.

Changes in the 10-year Treasury yield tell investors a great deal about the economic landscape and global market sentiment. Professional investors analyze patterns in 10-year Treasury yields and make predictions about how yields will move over time.

When confidence is high, prices for the 10-year drop and yields rise. This is because investors feel they can find higher-returning investments elsewhere and do not feel they need to play it safe. Thus, gains in yield signal global economic confidence

Declines in the 10-year Treasury yield generally indicate caution about global economic conditions.

  • BecauseTreasury securities are backed by the U.S. government, They securities are seen as a safer investment relative to stocks.
  • Bond prices and yields move in opposite directions—falling prices boost yields, while rising prices lower yields.
  • The 10-year yield is used as a proxy for mortgage rates. It’s also seen as a sign of investor sentiment about the economy.
  • A rising yield indicates falling demand for Treasury bonds, which means investors prefer higher-risk, higher-reward investments. A falling yield suggests the opposite.

The yield is the rate that people refer to when they’re talking about Treasuries. The coupon rate, while technically the interest rate you will receive in relation to the Treasury’s face value, will likely be different from the effective yield you end up getting. If you pay less than face value, your effective rate will be higher; more and it will be lower.

Prices (and therefore effective yields) change for bonds almost constantly. That’s because a bond’s price is inversely related to yield: When demand is high and Treasury prices rise, yields fall—conversely, when demand is low Treasury prices fall and yields rise.

Rising yields may signal that investors are looking for higher return investments but could also spook investors who fear that the rising rates could draw capital away from the stock market.

References:

  1. https://www.forbes.com/advisor/investing/10-year-treasury-yield/

Benchmark 10-year Treasury Yield

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Short term US Treasury yields reached their highest level since July 2007 last week, after new official data revealed the US economy is still coming in hot, reports Forbes Magazine.

The benchmark 10-year Treasury yield climbed to 3.87%, while the 2-year rate advanced to 4.669%. The one-year Treasury yields briefly hit 5%. The last time the it hit those levels was July 2007.

High yields affect the price of bonds, which are considered to be the ultimate safe investment. They’ve been sensitive to the new data on the US economy’s health, which isn’t behaving as the Fed expected.

The ten-year Treasury yields, which many use as a benchmark for the economy, hit their highest level since December 30.

Treasury yields are kind of a big deal. They influence how much it costs the US Government to borrow money, how much interest bond investors will get and the interest rates everyone pays on loans.

And the 10-year Treasury yield is the jewel in the crown. It’s used to measure mortgage rates and confidence in the market. If the yields are higher here, it could grind the housing market to even more of a halt.

  • Treasury yields hit new highs in February, with 10-year yields hitting 3.86% and two-year reaching 4.6%
  • The highs come after data on labor and prices showed the US economy still had a long way to go to get inflation down
  • 10-year vs. 2-year bond yields are currently in an inverted curve, which historically has predicted a future recession

An inverted yield curve happens when the shorter-term yields have higher returns than the long-term yields. An inverted curve has historically meant a recession is on the way, and that can be enough to scare off banks from lending.

Investors are worried that stubborn inflation will lead the Federal Reserve to keep raising rates and to keep rates higher for longer — which could tip the economy into a recession.

References:

  1. https://www.forbes.com/sites/qai/2023/02/20/treasury-yields-hit-new-heights-is-inflation-set-to-stick-around/amp/

The 10-Year Treasury Bond Yield

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The 10-year Treasury bond yield is closely watched as an economic indicator of broader investor confidence.

An economic indicator is a piece of economic data, usually of macroeconomic scale, that is used by analysts to interpret current or future investment possibilities, according to Investipedia. .

This 10-year bond signals investor confidence. The U.S Treasury sells bonds via auction and yields are set through a bidding process.5 When confidence is high, prices for the 10-year drop and yields rise. This is because investors feel they can find higher-returning investments elsewhere and do not feel they need to play it safe.

But when confidence is low, bond prices rise and yields fall, as there is more demand for this safe investment.

This confidence factor is also felt outside of the U.S. The geopolitical situations of other countries can affect U.S. government bond prices, as the U.S. is seen as safe haven for capital.

  • BecauseTreasury securities are backed by the U.S. government, They securities are seen as a safer investment relative to stocks.
  • Bond prices and yields move in opposite directions—falling prices boost yields, while rising prices lower yields.
  • The 10-year yield is used as a proxy for mortgage rates. It’s also seen as a sign of investor sentiment about the economy.
  • A rising yield indicates falling demand for Treasury bonds, which means investors prefer higher-risk, higher-reward investments. A falling yield suggests the opposite.

Changes in the 10-year Treasury yield tell long-term investors a great deal about the economic landscape and global market sentiment. Professional investors analyze patterns in 10-year Treasury yields and make predictions about how yields will move over time.

Declines in the 10-year Treasury yield generally indicate caution about global economic conditions while gains signal global economic confidence.

Prices (and therefore effective yields) change for bonds almost constantly. That’s because a bond’s price is inversely related to yield: When demand is high and Treasury prices rise, yields fall—conversely, when demand is low Treasury prices fall and yields rise. This ebb and flow ultimately creates the Treasury pricing market as people flock to (and then from) Treasuries based on the economic environment they find themselves in.

It’s important to remember, all U.S. Treasury securities are regarded as risk free—since they’re backed by the full faith and credit of the United States government, which has never defaulted on its debts.

When investors get worried about the economy and market risk, they look for safe investments that preserve capital, and Treasuries are among the safest investments out there.

One of the foundational principles of finance is that risk and return are correlated. When markets are booming and the economy is expanding, the appetite to take on risk and generate returns is high. Risk-free Treasuries become much less appealing because of their lower returns. Demand declines and Treasury notes sell at less than their face value.

References:

  1. https://www.forbes.com/advisor/investing/10-year-treasury-yield/

World in Love with Debt

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“There is $50 trillion more in world debt today than there was in 2018.” And that will hurt equities. Larry McDonald

2021 global debt database shows largest one year debt surge post World War II to $226 trillion, i.e., 256% of global GDP in 2020. Government borrowing was half this increase; global public debt rose by 20% to an unprecedented level in over 50 years.

In a financial sense, the bond (or debt) market dwarfs the stock market. Although the rise in interest rates has been devastating for bond investors because of the inverse relationship between rates (yields) and bond prices. In actuality, both the debt and equity markets have fallen this year.

Yet, “The world is still in love with debt,” according to analysts at Bank of America Merrill Lynch. Debt vulnerabilities are rising, with potential costs and risks to debtors, creditors and, more broadly, global stability and prosperity. But, does it matter. After all, world governments owe the money to their own citizens. The rising total global debt is important for two reasons.

  • First, when debt rises faster than economic output (as it has been doing in recent years), higher government debt implies more state interference in the economy and higher taxes in the future.
  • Second, debt must be rolled over at regular intervals. This creates a recurring popularity test for individual governments’ sovereign bonds. Fail that test, as various euro-zone governments have done, and the country (and its neighbors) can be plunged into fiscal and economic crisis.

If the Federal Reserve raises the federal funds rate by another 100 basis points and continues its balance-sheet reductions at current levels, “they will crash the market,” states Larry McDonald, founder of The Bear Traps Report and author of “A Colossal Failure of Common Sense”.

A pivot may not prevent pain

McDonald expects the Federal Reserve to become concerned enough about the equity market’s reaction to its monetary tightening to “back away over the next three weeks,” announce a smaller federal funds rate increase of 0.50% in November “and then stop.”

References:

  1. https://www.msn.com/en-us/money/markets/the-stock-market-is-in-trouble-thats-because-the-bond-market-is-very-close-to-a-crash/ar-AA12Q8kd
  2. https://www.businessinsider.com/baml-global-debt-has-rise-by-50-trillion-since-the-financial-crisis-2015-10
  3. https://www.imf.org/external/pubs/ft/ar/2022/in-focus/debt-dynamics/

I Bonds

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The main benefit of I Bonds is that they protect your cash from inflation. I bonds currently earn 7.21% through April 2022.

U.S. Treasury issued Series I savings bonds are a low-risk savings product. They are a good hedge against inflation (the “I” in the name stands for “inflation”), because during their lifetime they earn interest and are protected from inflation.

Inflation can be a very destructive economic force that reduces the value and purchasing power of your money over time. With inflation at a 40-year high, many investors are looking for ways to protect the value of their cash, and Series I bonds could be a good solution.

These Series I bonds have two interest rates:

  • A fixed rate that never changes for as long as you hold the bond — currently 0%
  • A variable inflation adjusted rate that changes every six months based on the Consumer Price Index (CPI) — current annual rate is 7.12% through April 2022.

The Treasury will announce the new I bond annual interest rate based on CPI in May, which might be higher or lower than the current rate.

You may purchase:

  • Electronic I bonds via TreasuryDirect.gov
  • Paper I bonds with your IRS tax refund via IRS Form 8888

I bonds are sold at face value and earn interest from the first of the month in the issue date. Interest is earned monthly and is compounded semiannually:  the interest the bond earned in the previous six months is added to the bond’s principal value; then, interest for the next six months is calculated using this adjusted principal.

Interest accrues until the bond reaches 30 years maturity or you cash the bond. You can’t access the interest payments until you cash the bond.

I bonds do not incur state or local taxes (SALT), but the bond owner will owe federal tax on the interest earnings unless the money is used for qualified education expenses.

You can’t redeem the bond for at least 12 months, and if you redeem the bond within five years, you forfeit the last three months of interest.

There are dollar limits on the quantity of Series I bonds you can purchase each calendar year:

  • $10k maximum in electronic bonds per person (minimum $25)
  • $5k maximum in paper bonds (minimum $50)

You can also purchase bonds for children under the age of 18 and, in some instances, for trusts and estates.

The main benefit of Series I bonds is that they protect your cash from inflation. And, Series I bonds can be a good solution if you have a savings goal over the next 2 to 5 years and want to protect the value of your savings.

References:

  1. https://www.treasurydirect.gov/indiv/products/prod_ibonds_glance.htm
  2. https://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds.htm
  3. https://facetwealth.com/article/series-i-bonds/