Why bond prices move
An increase or decrease in Treasury yields is driven by the macroeconomic scenario. When the economy is on a downturn, investors get out of other riskier asset classes such as stocks and real estate and invest their money in fixed income securities, which are considered a relatively stable asset class due to the predictability of cash flows. Moreover, central banks (like the U.S. Fed) maintain loose monetary policy during a downturn to encourage capital investments and consumption growth to boost the economy. As bond prices and interest rates hold an inverse relationship, bonds gain in a downturn as interest rates declines. The opposite is true for an economy undergoing a boom.
So, why do bond yields and prices share an inverse relationship?
As our readers may know, bond investments fetch investors two kind of cash flows. One is the periodic coupon payment (often quoted as an annualized percentage of face value and paid semiannually) and the other is redemption price (the exit price for a bond investor). As the cash flows are future cash flows, they’re discounted to their present value and added up to arrive at current bond prices. The discount rate is nothing but the return investors expect out of their bond investments. As investors expect greater returns from their bond investments when interest rates rise, they value future cash flows less favorably, leading falls in bond prices. The opposite holds true for a fall in interest rates.
So, what do weekly fluctuations in Treasury yields tell us?
Weekly Treasury yield fluctuations serve as an important indicator to gauge investors’ perception of the economy. An improving economy means people are better off. As people earn more money, they spend more for the same product or service than they did in bad times, leading to inflationary pressure. Central banks raise interest rate in response to make the money supply costlier and ward off inflationary pressure. So a rise in yields continuously for a few weeks is a sign of improving economic conditions. The opposite holds true for a worsening economy.
In a booming economy, investors prefer to stay invested in equities to benefit from the upside they offer. Investors can invest in broad-based ETFs such as SPDR S&P 500 ETF (SPY), with top holdings in Apple Inc. (APPL) and Exxon Mobil Corporation (XOM). In a falling economy, investors can stay safe by investing in risk-free Treasury securities and ETFs such as the ProShares UltraShort 20 Year Treasury (TBT).
If investors want to stay invested in bonds even in an improving economy, corporate bonds—particularly high yield bonds—are a better bet than Treasuries, as they offer higher yield and are less sensitive to changes in interest rates than Treasuries. Some ETFs, such as the iShares iBoxx $ High Yield Corporate Bond Fund (HYG), invest particularly in high yield bonds.
To learn more about movements in Treasury yields over the past week, read on to next part of this series.
© 2013 Market Realist, Inc.
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