Why should we worry about bond yields increasing?

Hello my friend! I had hoped that after talking to you about recession last time, I would have something positive to talk about today but I am afraid there has been no good news since then. How are you holding up?

Hellooo…yes I remember leaving our last conversation with being hopeful about the future but I guess we will have to wait some more. I have just tuned out the noise for a bit because it really is not helping me relax and think clearly.

That is an excellent strategy! I will try that myself because I get worked up hearing about the turmoil in the financial markets and feel like I need to do something. I then remember your advice on not making decisions when you are emotional or overwhelmed, especially when it comes to financial decisions, so here I am trying to distract myself and talk to you.

I am glad you remember that advice because it is most relevant for times like these when there is a headline everyday and each seems worse than before. In my experience, making rash decisions during these times hurts you the most in the long run. I am always there for you when you need to talk, so what did you have on your mind today?

Well, among all the financial news, the one that piqued my curiosity the most was about the bond yields increasing. I know we have talked about bonds before and how they are useful for managing the US debt [Check out this blog to learn about how US debt is managed by bonds and how it affects you] but I could not understand why increasing yields during these times is a bad thing. Can you share your thoughts on that?

Yes, that is an interesting topic to talk about and what we already talked about the US debt will be a nice backdrop to this conversation. Let’s first recap about what bonds are and how they are relevant to the US government.

Bonds are simply debt instruments that are used by governments, municipalities, corporations, etc to borrow money for their needs. In return, they offer to pay an interest on the borrowed money, which are called coupon rates. The coupon payment or interest payment divided by the amount borrowed is called bond yield. All bonds come with a maturity date that is when the borrower returns the principal amount along with the interest. For some bonds, the interest is paid at regular intervals till the bonds reach their maturity date. For example, the US treasury bonds pay interest every 6 months. This fixed source of income till maturity and very low risk of losing the principal amount makes bonds a safe investment. One key thing to know about the bonds is that their price is inversely related to their yields i.e. a higher bond price means a lower bond yield. 

Let us understand the relation between bond prices and yields with an example, let’s say you buy a  corporate bond for $100 that has a coupon rate of 5% and a maturity term of 1 year, which means that you will be $5 at the end of the year along with the $100. This means that the bond yield is $5/$100, which is 5%. Now, let’s say that during the same year, this corporation needs more money and has to issue another set of bonds but because they need the money desperately, they want to make these bonds more attractive, so they offer a yield of 10%. Now, people like you, who hold the bond that gives out only 5% yield will try to sell their bonds and purchase the new ones, so the price of the old bonds will decrease since there will be more supply than demand. The price of the old bond which had a coupon rate of 5% will decrease till it also has a 10% yield and then it can become equivalent to the new bonds. This means the price of the bond has to drop to about 95.5 because when you get a payment of $105 as promised by the old bond, this will mean a yield of 10% (=$9.5/$95.5). This is how the bond market works and the prices of bonds fluctuate based on the yields offered by the newly issued bonds.

Now, bonds are important for the US government because they also need to borrow money to support their expenses.  The US government via US Treasury Departments offers different types of bonds based on their maturity dates. The most popular ones are the US 10 year Treasury note and US 30 year Treasury bonds.

[Check out this blog to learn about the other types of bonds that the US Treasury Department offers] All the bonds are sold on the US Treasury website via online auctions where the investors, which include financial institutions, individual investors and governments all over the world, bid for the price and yield that they are willing to buy the bonds for. This bidding process is what sets the yields for the bonds, which is what you kept hearing about in the news. You can view the yields on bonds as an interest rate on the loan, so if the auction results in a higher yield for the bonds issued, then the interest payment on those bonds will be high. Therefore, it is in the interest of the US government to have the yields on the bonds to be low such that their interest payments are not too high.

Thank you for the recap! I recall our conversation about the bonds and US debt. You had mentioned that several factors like inflation, state of economy, faith in the US government, etc. determine the yields on the bonds that the investors demand in the auction. If the yields they demand are high then it is bad because the borrowing costs for the government increases. Also, it impacts all the loans that people like me are interested in like car and home loans. A higher yield on US bonds sets a higher interest rate for all these loans because US bond yields are used as a basis or reference to calculate interest rate on all other loans. 

I also understand the relation between bond yields and bond prices. It makes sense that if there are bonds that have higher yields in the market then the bonds which have lower yields will have to reduce their price to become competitive. These are simply market forces at play here that are looking at supply and demand of bonds.

Now, the question is why were financial analysts worried about bond yields increasing?

The main reason why the analysts were panicking is because of the context in which bond yields were going up. As you know the trade policies were creating a lot of uncertainty which the investors did not like and this resulted in them selling investments in stocks. If you remember the value of a stock price is dependent on its future earnings and in recent times the future earnings are expected to decrease or at least uncertain because of the potential trade policies. This drop in expectation of future earnings reflected in the stock price drop of the majority of companies in the stock market. 

[Check out this blog to find out how the price of a stock is determined]

 Usually when investors sell their stocks as they become less attractive due to economic uncertainty, they usually resort to safer investments, which are bonds. The safest of all bonds are those offered by the US government since they are the most trustworthy borrowers in the world at this point. If the investors start buying bonds then the prices of bonds will increase as the demand will be higher than the supply during these times. As we discussed before, an increase in bond prices will mean a drop in bond yields. However, the yields on the long term US bonds like the 10 year Treasury note increased which was very unusual and attracted a lot of attention.

I see what the panic was all about. Things were not going as expected in the bond market. From experience we all know that in any scenario if things don’t go as expected people get worried. Was that the only reason these increases in yields were in the news or is there more to it?

You are right about the human reaction to things not going as expected. But when it comes to the increase in bond yields, there were other implications which were scaring the analysts

1. Loss in faith in the US government – An increase in bond yields meant that investors probably do not consider the US government to be a trustworthy borrower and hence do not want to lend them money by buying US Treasury bonds. This is not good because the US government needs to borrow money to sustain its expenses and if investors are not willing to lend their money or lending at higher interest rates then it could mean an increase in the borrowing costs and less money available to spend on important government expenses like healthcare, defense, infrastructure and social security.

2. High interest rates on loans for people and businesses – As we have talked before, the US bond yields impact the interest rates on home and auto loans. So, if the yields on bonds increase then the home and auto loans will become less affordable due to higher interest rates. This will reduce the demand for homes and cars, which will have a ripple effect on other industries that support home construction and car manufacturing. Overall, there will be a reduction in revenue for several businesses, which will affect their profits and they may have to lay off people to stay profitable. Also, reduction in spending could also lead to a recession which can further scare consumers from spending and exacerbate the situation. Even the spending by businesses will reduce as they will not be able to borrow at cheaper rates, which means they will not want to expand their operations, invest in R&D, etc. This will reduce employment opportunities for people and also stifle innovation, which is key to increasing GDP growth via productivity gain. All in all this will be bad for the overall economy and majority of the people will suffer.
3. Crash in stock market – If the bond yield increase then that means the rate of return on risk-free investment will go up. This will deter investors for putting money into the stock market since it is more risky and there is no guarantee of a return on investment. As investors sell their stock investments, this will reduce the stock prices and more importantly reduce the amount of money for businesses to spend. A lot of people will have their retirement money in the stock market, which will go down in a value and put pressure on them to survive on a lower budget. 

Wow! Those are some serious consequences to increasing bond yields. I am always fascinated how something so trivial can have such major impacts. I now have another thing on my plate to track and be worried about! Thank you so much for talking through this and helping me understand what the fuss is all about. At least being informed will help me stay calmer than before because I will know what the fuss is all about!