- When bond yields increase, investors may find stocks less attractive and favor fixed-income instruments;
- Rising consumer debt costs caused by higher interest rates mean consumers have less money to spend; purchases requiring financing are put off because of higher finance charges. Both can have a negative impact on corporate earnings;
- Corporations face higher financing costs, and reduced earnings, due to rising interest rates.
Telling Curves: What Bond Yields Reveal About the Markets
by Wayne A. Thorp
Yield curves, as we shall see, are graphical depictions of where interest rates stand at any given time. And interest rates can have a significant impact on stocks.
Interest rates can impact stocks because of three factors:
Studies have shown that the overall pattern of interest rate (yield) movements can provide an indication of the direction of future economic activity and the markets themselves. As a result, it is prudent for individual investors to pay more than tacit attention to interest rates.
One way in which to monitor the overall movement of interest rates (or yields) is with a yield curve.
What is Yield?
Before discussing bond yield curves, however, lets review the definition of a bond yield. A bonds current yield relates the annual dollar coupon interest to its market price. It is the annual dollar coupon interest divided by the price of the bond.
The most popular yield measure is the yield to maturity (YTM). The yield to maturity is the interest rate that will make the present value of a bonds cash flows equal to its market price plus accrued interest. It is similar to an internal rate of return (IRR) calculation, where the cash flows used are those to be received if the bond is held to maturity. In order for an investor to realize the yield to maturity, however, he must reinvest all of the coupon payments at an interest rate that is equal to the yield to maturity.
When rates change for short-, intermediate-, and long-term bonds, the resulting change in the respective bonds prices will differ, even for equal rate changes among maturities. The price of a bond is the sum of the present value of all future payments from the bond. The present value of the future payments is calculated by discounting them; the rate that is used is the yield to maturity. Therefore, a given rate change has a larger impact on the price of a long-maturity issue than a short-maturity issue, because the longer-term issue makes more future payments. As a result, the discounting process takes a greater toll for longer-term maturity issues.
Shorter-term bond prices are affected less by changing rates than long-term bonds. Rising rates, which lower the price of a bond, result in a decrease in the prices of long-term issues that is greater than the decrease in price for short-term issues. Therefore, if you believe rates are going to fall (bond prices will rise), you would buy the longest-term bond in order to reap the greatest benefit from the falling rates and rising bond prices. The opposite strategy is to buy short-term bonds when you expect interest rates to rise.
What is a Yield Curve?
The yield curve is a graph of the yields to maturity (interest rates) on similar-quality fixed-income securities (i.e., bonds), but with different maturities. For every type of bond, there is an accompanying yield curve—corporate bond curves, municipal bond curves, and so on. While you may read about interest rates climbing or falling, it is important to realize that rates differ depending on the maturity of the underlying security. In other words, the rates (yields) of bonds of different maturities may move independently of each other, with short-term rates and long-term rates often moving simultaneously in opposite directions.
Economists use the yield curve to capture the overall movement of interest rates. A typical yield curve plots the yields for various maturities of U.S. Treasury instruments—bills, notes, and bonds. Treasury bills, or T-bills, have maturities of less than one year. Treasury notes (T-notes) have maturities of one to 10 years, and Treasury securities with maturities greater than 10 years are Treasury bonds.
Figure 1 is an example of the Treasury yield curve based on Treasury Department data as of March 24, 2003. As the graph shows, the line begins on the left with the shortest maturity Treasury instrument, the one-month T-Bill, and ends on the right with the longest—in this case it is the average yield of Treasuries with maturities of 25 years and greater.
The Normal Yield Curve
Ordinarily, short-term fixed-income instruments carry lower yields (interest rates) than those of long-term instruments, reflecting the fact that the investors money is under less risk. In general, the longer your money is tied up with an investment, the more you should be rewarded for the risk you are taking. Therefore, a normal yield curve slopes upward as maturities lengthen and yields rise. A normal curve is indicative of an economy that is expected to grow at normal rates of growth without significant changes in inflation or available capital.
There are times, however, when the curve is not normal and instead forms other recognizable shapes, with each signaling a potential turning point in the economy.
Steep Yield Curve
The spread (difference) in yields between 30-year Treasury bonds and three-month Treasury bills is typically around three percentage points (300 basis points), with the yield on the 30-year bond exceeding that of the three-month bill. When this difference increases—the spread widens and the slope of the yield curve increases sharply—long-term bondholders are signaling their belief that the economy will improve quickly in the future and interest rates will rise.
It is common to see a steep yield curve at the beginning of an economic recovery or expansion, usually following a recession. At that point, short-term interest rates have been driven downward by the Federal Reserve in the hopes of jump-starting the economy. However, once the demand for capital is reestablished by increasing economic activity, rates tend to begin to rise.
Given this definition of a steep yield curve, the yield curve presented in Figure 1 would be classified as such, with the spread between the 30-year Treasury bond (in this case, the average yield of Treasury securities with a maturity greater than 25 years) and the three-month Treasury bill at 3.74% (4.89% - 1.15%). Whether a quick economic recovery is in the near future remains to be seen.
During most of 1992, the spread between the 30-year T-bond and the three-month T-bill was above 4%, based upon monthly yield data published by the Federal Reserve. This is illustrated in Figure 2, where the lighter line indicates the spread. In fact, the largest spread (using monthly yield data) between the two for the period of January 1982 through February 2002 (the last time monthly 30-year T-bond yields were published by the Federal Reserve) occurred in October 1992, when it reached 4.6% (7.53% - 2.93%).
In 1990, the gross domestic product (GNP) of the United States grew by 1.8% and contracted by 0.5% in 1991. In the fourth quarter of 1992, GDP grew by 5.4% on an annualized basis; GDP grew by 3.0%, 2.7%, and 4.0% in 1992, 1993, and 1994, respectively.
After being relatively flat for most of 1992, the Russell 3000 index bottomed out on October 9, 1992 (black line in Figure 2). Upon peaking on February 2, 1994, the index had gained 22.4%. During this same period, the spread between the yields on the 30-year T-bond and the three-month T-bill fell from 4.6% to 3.16%, while reaching a low of 2.85% in October of 1993.
Inverted Yield Curve
Once in a great while, a condition arises where the yields on long-term Treasuries are less than those of short-term instruments. When this occurs, the yield curve is said to be inverted.
During periods when the yield curve is inverted, long-term investors are willing to accept lower yields than short-term investors while taking on greater risk. This is because there is a prevailing belief among long-term investors that rates (yields) will fall even farther and they are willing to lock in rates before they do fall.
From July to December of 2000, the spreads between monthly yields for the 30-year Treasury bond and the three-month Treasury bill were negative, ranging from -0.29% to -0.58%. This is illustrated by the lighter line in Figure 3. While GDP in the U.S. grew at a relatively healthy 3.8% in 2000, its pace slipped to an anemic 0.3% in 2001, with negative growth taking place in the first, second, and third quarters of 2001—a recession in technical terms. In the first half of 2000, the Russell 3000 peaked and over the next two and a half years, the index shed 31.6% before reaching a bottom in early October 2002 (black line in Figure 3).
On its way to becoming inverted, a yield curve must pass through a period where long-term yields are roughly equal to those of short-term yields. When this happens, the yield curve is flat or, more often, will be slightly raised in the middle, giving it a hump-like appearance. Whereas an inverted yield curve is a strong indicator of coming economic malaise, a flat or humped yield curve does not always become inverted. That is not to say, however, that they should be ignored, as an economic change may be forthcoming.
The following two examples prove this point. Between February 1982 and June 1982, the spreads between the monthly yields of the 30-year T-bond and three-month T-bill were between -0.06% and 0.84%.
Furthermore, the spread between 30-year T-bond and the 10-year T-note was slightly negative, with the yield on the 10-year exceeding the 30-year—meaning the yield curve was slightly humped for the intermediate maturities. Within a few months of the flat yield curve forming, the spread between long-term and short-term Treasuries had risen to almost 4%. While GDP did fall by 2% in 1982, it rose by 4.3% and 7.3% in 1983 and 1984, respectively. In this case, while the yield curve did not become fully inverted, the flat curve did accompany a period where GDP contracted in three of four quarters in 1981 and 1982.
In contrast, the inverted yield curve of 2000 was preceded by five months where the spread between long-term and short-term Treasuries was below 0.5%.
Predictor of Recessions?
While it is one thing to say that the yield curve can be used as a forecasting tool for future recessions, it is another to back the claim up with actual research. A study published by the Federal Reserve Bank of New York in 1996 shows that, as the spread between the 10-year Treasury note and the three-month Treasury bill becomes increasingly negative, the probability of a recession within the following four quarters increases significantly. By studying the yield curve from the first quarter of 1960 to the first quarter of 1995, the research found that the estimated probability of a recession four quarters ahead is 10% when the spread averages 0.76% over the quarter, 50% when the spread averages 0.82%, and 90% when the spread averages -2.40%.
The advantage of the yield curve is then two-fold:
First, the data used to construct the yield curve is readily available, which means individuals can construct their own yield curves or access numerous Web sites that provide this information (see the box at the end of this article for sources of bond-related data and information).
Secondly, this relatively easy to analyze graph is a reasonably accurate forecasting tool.
A good stepping stone for those new to bond investing. Numerous investor guides explain bond basics as well as provide a discussion of the types of bonds that are available. The daily Treasury report shows the maturity date, bid/offer, and yield for one-, three-, and six-month Treasuries, as well as two-, five, 10-, and 30-year Treasury bonds, along with a yield curve.
TreasuryDirect www.treasurydirect.gov Users can purchase U.S. Treasury securities—Treasury bills, notes, and bonds as well as inflation-indexed I bonds—directly via the Internet. Also provides the basics of Treasury securities and a frequently asked questions (FAQs) area. There are links to Treasury auction schedules and results dating back to the 1970s and rate information for Treasury securities.
BondsOnline.com www.bondsonline.com Provides information, education, and data on fixed-income instruments, ranging from corporate and municipal bonds to Treasury securities and savings bonds. Current data includes the Treasury yield curve, composite bond yields, and corporate bond spreads.
StockCharts.com—Dynamic Yield Curve www.stockcharts.com The dynamic yield curve shows the relationship between interest rates and stocks over time. Users will find both the yield curve and a graph of the S&P 500; click anywhere on the S&P 500 chart to see what the yield curve looked like at that point in time.
SmartMoney.com—Economy & Bonds Home www.smartmoney.com/bonds Provides bond news, analysis, and educational content. Includes a bond allocation worksheet and a risk analysis tool. A bond calculator demonstrates the effects of price and yield changes. Also offers a bond primer and explanations of the yield curve.
Bloomberg Online www.bloomberg.com Within the Markets section of Bloomberg.com, you will find access to key interest rates and current price and yield data for U.S. Treasuries and inflation-indexed Treasuries. Coupon, price, and yield data is also provided for bonds of varying maturities from several countries.
Wayne A. Thorp, CFA, is financial analyst at AAII and associate editor of Computerized Investing.