What Really Happens When Bond Yields Move?
Guest Post by Dennis Miller at Miller On The MoneyThe Fed raised interest rates on 10-year treasuries to 5.15%, the same level it was before the 2007 financial crisis.
The political media went into a frenzy, one side emphasizing a booming economy and the stock market hitting new highs. Opponents scream home prices are cratering, people can’t get mortgages and small businesses are failing. Yeah, OK…..
While I’ve often criticized the Fed’s propeller heads economists, they consider the impact of every rate decision to raise, lower or stay the same. The Fed has been manipulating rates for over a century, and all phases of the economy must adjust. Let’s calm down and take a look.
What is a Bond?
When individuals and small businesses need to borrow money, we go to a bank. When big companies and governments need money, they sell IOUs to the public – called bonds. Bonds include an interest rate, payment terms, and a redemption date, many times 20 years or more in the future. Those factors, along with default risk, determine their market value.
Investment houses purchase these bonds and resell them to investors individually or packaged in a fund. Many of these are held in IRAs, etc.
The big kahuna in the bond market is the US government with over $40 trillion in outstanding debt. US treasury yield serves as a bench mark for the world.
Why bond prices move
Generally, individuals buy bonds for the income and hold them until maturity. Traders buy and sell bonds. The aftermarket resale value may swing wildly, but at maturity, the bond holder receives par value.
Over the life of the bond, there are many factors which cause it to become more/less attractive to investors, resulting in changes in resale value:
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Let’s begin with the first two, interest rate changes and inflation concerns.
US Treasury yieldcurve.com shows since 2020 interest rates on 10-year treasuries have risen ten-fold, from a low of .5% to over 5%.
When interest rates increase, resale prices of existing bonds generally decrease. With the adjusted lower price, the yield to the buyer (a combination of interest and gain at redemption) is similar to what would be earned if the buyer bought a new bond at current rates.Marketbeat tracks the current market value of the Vanguard Long Term Treasury ETF over that time period. This fund holds multiple long-term treasuries with various dates for maturity.
As interest rates have been rising, the share price has dropped almost 45% over the last five years.What does that mean? If you hold that fund in your 401k, you are likely to say “woe is me” as the share price dropped. If you own individual bonds, you can choose to accept lower than current interest rates and be paid in full at maturity – or you can sell at a loss.
The Underlying Secret in plain sight!
In 1999 the Glass-Steagall Act was repealed allowing banks to consolidate and merge with investment (brokerage) firms. That opened the floodgates; banks lent to anyone and everyone regardless of risk, and packaged those loans and resold them through their investment division.
In an effort to slow down inflation, the Fed slowly began raising rates back to where they were before the whole mess began.
However, this creates a problem. In order to judge bank solvency, banks report their assets as “mark to market;” valuing their assets at current market value. They are required to hold “safe” government bonds, with billions now worth much less if they tried to resell. They soon will be crying foul, looking for another bailout. Screw that, let them earn less profit and hold those debts until maturity.
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[ H/T The Burning Platform ]
