October 2021 Newsletter to Clients

Enjoy this month’s edition that features a description of bond yields and what those can tell us.

Radio and television news routinely announce how the Dow Jones Industrial Average or the S&P 500 performed that day as part of their broadcast. A number that deserves way more attention than it receives, however, is the yield on the 10-Year U.S. Treasury note. It doesn’t get much notice, nor do many people understand its significance, but that yield can tell us a lot about inflation, the direction of the stock market, and the economy in general.

For background, the yield on the 10-Year U.S. Treasury note refers to the income an investor would receive during a year if they bought that note today. So, when one buys this note they purchase a note guaranteed by the full faith and credit of the United States government – often referred to as the risk-free rate because investors believe there is no chance the U.S. will default on their debt obligations. A note would be purchased for $100 and the purchaser would receive a set amount of interest, called the coupon, for the decade the investor owns the note. A note purchased today would pay approximately 1.60% interest per year – that is the note’s yield. At the end of that 10 years, the federal government pays the investor back their original $100.

What can that yield tell us?

• Bond prices: Counter-intuitively, bond prices move in the opposite direction of interest rates. So, when interest rates increase, bond prices decrease. As a result, as the yield on the 10-Year Treasury has increased from about 1.32% to about 1.60% over the past month, bond prices decreased. Here’s why: As interest rates increased to 1.6%, the demand for bonds that pay only 1.32% decrease. With less demand comes lower prices. Those price decreases affect the prices of the mutual funds we hold that invest in bonds, such as Dodge & Cox Income (DODIX) and Lord Abbett Short Duration Bond (LALDX and LLDYX), to name just a couple.
• Inflation: When investors expect inflation in coming years that sentiment is often reflected in the bond market in the form of higher yields. And, of course, lower bond prices. Inflation can erode one’s future purchasing power so investors demand higher yields on their bonds to compensate for this inflation risk.
• Economy: Similarly, bond yields can signal investors’ views on the direction of the economy. When the pandemic hit last year, bond yields plummeted – and bond prices soared. This reflected opinions that the economy would slow down during the necessary shut downs. Now that the economy is picking back up, yields are increasing.
• Stock market: Bond yields can also hint at the general direction of the stock market. Investors regularly compare potential returns of the bond market with potential returns of the stock market. When interest rates, and bond yields, are low, the returns of stocks can look more attractive in comparison. When bond yields rise, investors consider whether the expected returns of a company’s stock will be sufficient to compensate them for owning a riskier asset than a bond.

So, next time you hear or read the day’s markets recap, try and find how the 10-Year U.S. Treasury yield moved that day. It can tell you a lot.

Thank you for your continuing confidence.