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Bond yields and their importance to investors

The slope of the yields curve provides a good indication of economic turning points, the economic cycle and earnings growth.

Any investor following the markets, reading the business section of their favourite newspaper, or receiving a weekly newsletter from their respective investment company would have noticed an increased mention of bond yields and/or the yield curve over the past few months. Unless you are a professional investor, most individuals would have asked themselves what on earth is that? Are these factors that important and how are these factors linked to vital economic and market factors such as economic growth, inflation, interest rates, and earnings growth?

The short answer is yes, bond yields and the resulting yield curve are very important investment topics that tend to have a big effect on the market. I will attempt to put bond yields and the yield curve in perspective and explain their relative importance by answering some of the more generally asked questions about these topics.

What is a bond yield?

In short, a bond yield refers to the return on a bond when held until maturity. Maturity is the length of the bond’s life. Similarly, when one talks about the yield on cash, you refer to the return on cash. Just like cash, bonds give an investor income in the form of a coupon (like interest). Bonds also trade in the open market which means the price of a bond can fluctuate resulting in the bond yield increasing or decreasing.

What is the relationship between bond prices and bond yields?

The confusing part comes in when investment professionals and commentators talk about rising/declining bond yields and declining/increasing bond prices without distinction. That is because they are referring to the same thing. When bond yields go up it means that the price of the bond has decreased and vice versa.

Bond prices fluctuate with changing market sentiment and the economic environment. The greatest influence on bond prices is interest rates, which normally tend to change when inflation changes. Bond prices have an inverse relationship with interest rates. In other words, when interest rates go up the value of bonds (in the secondary market) goes down and vice versa.

What is the yield curve?

The yield curve is created from various data points. The yield curve is the line that forms when plotting the yields (return) of similar-quality bonds with different maturities, from the shortest to the longest maturity. This line can either be flat, slope upwards or downwards. The yield on a 2-year treasury note and 10-year treasury bond is used as the proxy for short-term and long-term rates. Some investors might use the 3-month treasury bill and the 10-year treasury bond yields when comparing short-term and long-term rates.

What are the different yields curves and what do they tell us?

If short-term bond yields are lower than long-term bond yields the yield curve is upward sloping and called a positive or normal yield curve. This indicates that market conditions and the economy as a whole are healthy and functioning normally.

If short-term bond yields are higher than long-term yields the line is downward sloping and called negative or inverted. An inverted yield curve is widely regarded as a bad sign for the economy. Getting more interest for a short-term than a long-term investment appears to make zero economic sense. One reason inversions happen is because investors are selling stocks and shifting their money to bonds. They’ve lost confidence in the economy and believe the minuscule return that bonds promise might be better than the potential losses they could incur by holding stocks into a recession. So, demand for bonds goes up and the yields they pay go down.

If there is little difference between yields the resulting yield curve is called flat. A flat curve indicates that there are no strong views on either growth or inflation.

Why is this important?

The slope of the yield curve gives an idea of future interest rate changes and economic activity. Inverted yield curves have proceeded every US recession since 1956. The last inversion began in December 2005 and heralded the Global Financial Crises (GFC), which officially began in December 2007. Then came the 2008 financial crisis. There was also an inversion before the tech bubble burst in 2001.

In South Africa, the slope of the yield curve has historically preceded changes in the economic cycle (by between three and eight months). Earnings growth for companies, and hence the overall market, move in tandem with the economic cycle and you would therefore expect the yield curve to precede the earnings growth of the market.

How is it relevant to my portfolio?

Over the longer term, the most important driver of share prices, and hence returns, is earnings growth. Where earnings go prices will eventually follow. The slope of the yields curve provides a good indication of economic turning points, the economic cycle and earnings growth.

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Werner Erasmus

Overberg Asset Management

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