10-year US Treasury yield reaches its highest level in 16 years – intro to some bond market basics

The 10-year treasury yield hit a high of 4.733% Tuesday morning, the highest level since August 2007, as investors still try to decide if and when a recession is coming.

How investors look at yields and the yield curve from an investing perspective – the risk-free rate

First, understand how investors use the price of treasuries. The treasury yield is often used to represent the risk-free rate. The risk-free rate is the rate of return one should expect on an investment with zero risk. This is a bit of an abstract concept, since nothing in life is guaranteed, but for investment purposes a treasury bill or note is the closest thing you’ll get, so that’s what investors use.

We’ll get into how investors price stocks and value companies later, but as a general rule, when making capital allocation decisions whether you’re an investor or a company, the idea is to start with the risk-free rate as a basis for all your decisions, then add in risk expectations for a given investment to price the investment relative to the risk free rate of return. So for example if an investor calculates that a stock is expected to return 9%, and the risk free rate is 5%, then the investor did some calculation to deem that the stock should earn a 4% premium over the risk free rate (there is a formula for this we’ll discuss in future letters).

This is how all investors think – analysis is done relative to something else, never in a vacuum. Because, if you think about it intuitively, investing is a proposition of scarcity which is a central theme of economics. I have one finite dollar, and an indefinite number of possibilities where I can put it, so I have to try to compare different possibilities against one another. 

Observing the treasury market from the investing perspective

The government issues bills, notes, and bonds (they’re all the same thing they just denote different lengths of maturity) on different timeframes. So a 1 month t-bill matures (expires) in one month, a 10 year treasury note in 10 years, and so on, up to the 30 year treasury bond.

In a normal, or positive, yield curve, bond yields increase as the maturity increases. This is because, if you want me as an investor to tie up my money for a longer period of time, you will need to compensate me for it. If I buy a 1 month bill, at the end of 1 month I have the option to reinvest it OR do something different with my money, that optionality has value. Compare that to buying a 2 year note – in one month I do not have any optionality because my money is still tied up, so I need to be compensated through higher rates on the longer dated notes and bonds.

A normal yield curve looks like this, with increasing yields as you buy longer dated bonds.

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Here are the yields on treasuries as of about 8am this morning, 10/3/23

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And here’s what that looks like plotted out on a graph. It looks odd relative to the normal yield curve and it violates what we just said about how investors should expect additional return for locking up capital for longer durations.

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This, today’s yield curve, is known as an inverted yield curve. Some would call this “humped” as it’s not directly sloping down, but consider the two types closely related, and this could be considered inverted. This is a sign of extreme uncertainty with an eventual recession, whereas an imminent recession would likely expect it to look directly downward sloping without the hump. Locking up your capital long term actually pays less than buying a short term bill and having the optionality to reinvest it or move it elsewhere. You have probably heard that inverted yield curves are a signal that the bond market expects a recession.

We can discuss an inverted yield curve in several ways, but for now, think about it this way: bond prices are negatively correlated with yields. In other words, when people sell off bonds, the yields go up. In normal times there is enough buying and selling that the market settles around the equilibrium normal yield curve we’ve seen above. But during an environment like today, there is so much uncertainty that very few investors want to hold short term bills, pushing their yields up higher than long term bonds.

Investors might be thinking they’d rather lock up money long term at our current high rates to ride things out, or they might be thinking that if a recession hits, rates will get cut, so they should take advantage of purchasing high rate long term bonds. All of these sentiments come back to the notion of short term uncertainty in the markets.

To complicate matters further, all of this assumes a stable currency and an economy experience normal cyclicality. We’ve been discussing the “shape” of the curve, as it’s known. There are many other factors that could influence the bond market. A country with an unstable currency could see its curve “pushed up” (or conversely it could come down over time reflecting stability. This signals that investors are demanding higher returns broadly from that country due to added risk, regardless of maturity. Remember the bond market is a global market, so just because we’re talking about the US government, there are buyers and sellers of US bonds inside and outside the US, and although the US has a history of low financial risk during modern times, it isn’t guaranteed to stay that way. If global bond investors see added risk to the US ability to pay while maintaining a stable currency (this is the key that is often ignored), then they could sell off US bonds, pushing the yield curve up.

Shape of the yield curve changing

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A hypothetical yield curve that got pushed up

In future letters we’ll continue to track the bond market, and we’ll also see the concept of risk free rate used in discussing investment analysis and corporate valuation.

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