On Friday I began discussing some key interest rates with you but barely scratched the surface. To be honest, I was writing you from the gorgeous La Estancia de Cafayate Golf Clubhouse and enjoying multiple welcome interruptions and conversations from new friends (and multiple glasses of the delicious local Torrontes wine), making it somewhat difficult to concentrate!

And interest rates, including what they are, what they mean to you, how they work, how they are set or determined, how they affect you personally and our larger global economy, how they are “governed” (and or “manipulated”) by various central banks, short-term vs. long-term rates, the yield curve, and more…are a rather ambitious topic to dig into on a Friday “QnA” blog post!

(Or as my good friend Gary says, “explaining interest rate management in a blog post is not for the faint of heart”!).

So today you’re in luck…I would like to spend a little more time on this (actually, a lot more time!).

As you know, I believe most “smart money” investors (to paraphrase Dos Equis, “the most interesting investors in the world…”) spend a lot more time analyzing the bond and credit markets than they do the stock markets.

In fact, these “interesting smart money” investors look at all kinds of bond market data to determine where to place their investment bets and to determine which asset class in which to invest in the first place.

And there is one specific type of bond that they pay the most attention to…the 10-year treasury bond.

10-year treasury bonds are considered benchmarks for their respective countries’ economies—you can tell at a glance simply by looking at a country’s 10-year treasury bond yield how the market perceives that country’s economy to be doing (in short: does the market believe the country can make good on its interest payments?).

Generally, anything above the magical 7% threshold signals trouble for a country attempting to make good on its outstanding loans (bonds).

Most sophisticated investors know the price and the yield of various countries’ ten-year treasury bonds to the day.

They know, for example, that:

  • “The yield on 10-year Treasury notes hit session lows early Monday, 3/26, as a persistent round of buying emerged after Federal Reserve Chairman Ben Bernanke expressed concerns about the sluggish labor market” (Reuters, 3/26), and that
  • “German bonds advanced, sending yields down to the lowest in almost four months, on concern Greece’s finances will worsen even as regional leaders prepare to sign off on the nation’s second bailout” (Bloomberg, 3/12), and that
  • “Spanish 10-year bonds advanced, reducing the extra yield investors demand to hold the securities over similar-maturity German bunds for a second day.” (Bloomberg, 3/26)

But what does this mean in plain English, and why do sophisticated interesting “smart money” investors care?

Let’s take these step by step and see if we can make sense out of them (and determine why we should care).

1. 10-year US Treasury note:

First off, we need to cover some basics.

You notice that the yield on the notes “hit session lows” as “a persistent round of buying” emerged. But does this make sense? Normally something hits a session high if a “persistent round of buying” occurs, right? For example, if there are a lot of people buying gold, you would expect the gold price to go up, not down.

But gold is different from bonds…gold has no yield, only a price.

Bonds on the other hand, have both a price and a yield (much like a dividend-paying stock).

So what is yield? Yield is simply the return you receive as a buyer for purchasing the bond—it’s the total return you receive on the bond including the price you pay for it.

In its simplest form, when you by a bond at its face value (or “par”) and hold it to maturity, the yield is simply the interest rate. For example, if you purchase a bond for $1000 with a 5% interest rate, your yield is 5%. (For the math geek in you, there is a formula for this:

yield = coupon value / price

The “coupon value” is the interest rate expressed as dollars—in our example the coupon amount of 5% interest on $1000 is $50.)

However, if you buy a bond for more or less than its face value, your yield reflects that, so the yield isn’t exactly the interest rate, although much of the time it is when bonds trade at face value, or “par”.

For example, if you can buy the same bond for only $900, you will have a higher yield than with the $1000 bond (5.6%). The coupon value stays the same ($50), but because you are buying it at a discount your yield is higher.

(Hopefully this makes sense…let me know if it does not and I can give some more examples!)

With bonds you are purchasing expected cash flow; not price appreciation or capital gains (although that is nice, and possible, too!). In fact, as a bond buyer, you are hoping to buy the expected cash flow as cheaply as possible—you want to be able to lock in your coupon value at the cheapest price possible (which increases your total return, or yield).

So when a lot of people are buying bonds, the price of those bonds goes up (just like in our gold example—they become more expensive because more people want them), but the yield goes down because you have to pay more for the same coupon value…you are paying more money for the same future cash flow.

Hopefully that makes sense, and addresses the first part of the US Treasury quote from Reuters above.

But what about the second part of the question…why do bond yields go down when Ben Bernanke expresses concern over the economy?

Bonds are seen by most investors as being less “risky” than stocks (whether or not that is true is highly debatable, particularly in our current environment, but that is how they are perceived). Therefore, when the Chairman of the Fed expresses concern over the “sluggish labor market”, investors tend to perceive more “risk” in the economy and therefore “rush into the safety and security of US Treasuries” (again, very mainstream thinking and highly debatable, but this is what you will see in the mainstream media news).

And why is the 10-year treasury note more “interesting” than the 30-year treasury bond?

Well, the U.S. government actually stopped issuing the 30-year treasury bonds for four years several years ago, from the end of 2001 through the beginning of 2006 (although they have since been reinstated), and the 10-year treasury note simply replaced them as the benchmark. The 10-year treasury is now seen by most investors as the best gauge of the economy, and is the benchmark around which consumer loans revolve.

Now with all of that back story we can quickly decipher the other two recent news quotes with ease:

2. “German bonds advanced, sending yields down to the lowest in almost four months, on concern Greece’s finances will worsen even as regional leaders prepare to sign off on the nation’s second bailout” (Translation: prices rose and yields fell because more people bought German bonds versus equities or other countries’ bonds due to higher perceived risk in the European economy)

3. “Spanish 10-year bonds advanced, reducing the extra yield investors demand to hold the securities over similar-maturity German bunds for a second day.” (Translation: Spanish bond prices also rose and yields fell, because the number of buyers increased…here they are comparing Spanish bonds to German bonds, rather than to equities, and so the Spanish bonds made some ground against the German bonds)

(We’ve discussed the Greek 10-year bond in detail previously…)

But now to the most important question of all…why should you care about this “magical” 10-year treasury rate?

This is a critical “big picture” (remember our conversation on yin and yang and your investing success!) macroeconomic indicator. Historically, these sovereign bonds have been considered very, very “safe”, but as we have seen recently with Greece this is no longer necessarily the case. You need to understand the “big picture” macroeconomic view as an investor to see whether or not certain asset classes are overvalued, undervalued, risky, or “safe”.

Here are just a few things I can glean from looking at the historically low U.S. 10-year treasury note:

  • U.S. treasuries are still perceived by the market as a whole to be a relatively “safe” asset, particularly when compared to other countries’ bonds around the world
  • The U.S. government is enjoying extremely low-interest rates on all of the debt that it must repay…I wonder what will happen if and when these interest rates increase and the government cannot make its payments?
  • The U.S. government and the Federal Reserve are pursuing a plan that encourages people to consume-consume-consume…as Doug Casey would say; not only is this the “wrong” thing, but it is the exact opposite of the “right” thing to do! Wealth is created by producing more than you consume and saving the difference.
  • The Federal Reserve has pledged to continue to keep rates down until at least mid-2014

What does the 10-year treasury tell you about our economy? I would love to hear what you think!

So there are some “bond basics” for you and I will continue the discussion tomorrow because there is much more to cover! (Yield curves, interest rate manipulation, and how the Federal Reserve “sets” this all important 10-year treasury rate…Short answer: it cannot directly, which is why it resorts to POMO’s).

More tomorrow…

Until then, stay thirsty my friend, and have a great week!

To your financial success,
— Kung Fu Girl

“I don’t always drink beer, but when I do, I prefer Dos Equis” — The Most Interesting Man in the World

“I don’t always look at interest rates, but when I do, it’s the 10-year treasury” — The Most Interesting Investors in the World