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Why all shareholders should pay attention to the bond market

We look at the importance of government bond yields, what they can mean for the outlook of the economy, and for shareholders.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

At the start of May, the yield on the 10-year US Treasury note hit 3% for the first time in more than three years. This made headlines all over the world, but why does it matter?

Whether you invest in bonds or not, yields on government bonds are worth paying attention to. Yields have an impact on everything from mortgage rates to borrowing costs. They can also impact how attractive shares look compared to other investments.

Before we look at why it matters, let’s start with a quick refresher on the basics of bonds.

This article isn’t personal advice, if you’re not sure whether an investment is right for you, seek advice. All investments, including the income from them, can fall as well as rise in value, so you could get back less than you invest.

What are government bonds?

In the UK, government bonds are known as gilts. Across the pond in the US, they’re called treasuries. They’re a loan to the government in return for an agreed rate of interest based on a pre-set ‘par’ value, paid at regular intervals. These payments are known as the coupons.

The loan will typically be for a set amount of time. Once it gets to the end of that period, a set amount of cash, known as the principle, will be returned along with the last coupon.

What’s the yield?

There are a number of different ways to measure the yield on a bond, some more complex than others. But the one we’re looking at here is the current yield. It’s calculated by dividing the bond’s annual coupon by its market price.

Here’s an example:

Imagine a government bond which pays 5% a year in coupons, with a par value of £1,000. The value of the annual coupons will be 5% of £1,000, so £50. If I buy this bond for £1,000, the current yield of this example is simply 5% (50/1,000 = 5%).

Once the bond’s been issued and it’s trading in the market, its market value can fluctuate. Assume I buy the bond again a year later for £1,100. The current yield now is 50/1,100 = 4.5%.

Example yield on a 5% bond

It highlights a key relationship in bonds, the price and yield move in opposite directions to each other. That means when one goes up, the other goes down.

I don’t own bonds, so why should I care?

A lot of shareholders might ask themselves why it matters that the 10-year US Treasury yield hit 3%.

It boils down to how shares are valued. One way to value a company is using a discounted cash flow method. This attempts to calculate the value of a company in today’s money, based on estimates of how much cash it will generate in the future.

The method relies on the principle that the value of £100 in the future is worth less today, because inflation erodes the value of money over time. If you buy £100 of groceries today, you won’t be able to get as much if you fast forward ten years and head to the shop with that same £100.

A discount rate is used as part of the calculation to bring those future cash flows back into a present-day value. The higher the rate, the less they’re worth today. That rate is typically based on the 10-year government bond yield.

On that basis, rising yields mean companies whose valuations are based on strong future cash flows (high-growth companies) will see their current day valuation drop. And the proof’s in the pudding, as we’ve seen this trend play out over the past few months as yields have risen.

Chart showing 10 year US treasury yield vs US growth stocks

Scroll across to see the full chart.

Past performance isn’t a guide to the future. Source: Refinitiv, 23/05/22.

The other impact of higher yields is it makes bonds more attractive for investors. The past few years has seen yields at rock bottom levels, meaning investors have been buying riskier investments to chase higher returns. As yields rise, investors tend to shift money away from riskier investments like shares, into ‘safer’ government bonds.

What is the yield curve and what does it tell investors?

The yield curve shows the interest rates available on government debt of varying timeframes. It’s used by economists and investors to help gauge the direction the economy’s travelling and sentiment among the markets. This certainly isn’t a crystal ball, but it’s a useful tool to understand and link into wider investment and economic analysis.

Here’s what a normal yield curve looks like.

Example of a normal yield curve

Under normal conditions, you’d expect the yield on a short-term bond to be lower than that of an equivalent bond with a longer maturity. All being equal, investors want a better return if they’re parting with their cash for a longer period. The steeper the curve, the more investors think conditions favour riskier investments. This can normally be a sign that economic growth is expected to be strong.

There are, however, times when the yield curve deviates from this baseline, and this is when investors should pay more attention.

Here’s the current yield curve of UK government bonds (GILTs).

UK GILT Yield Curve

Source: Bank of England, 19/05/22.

The flatter yield curve we’re currently seeing in UK GILTs has historically been a signal that a period of slower economic growth might be around the corner.

The next stage, which some think points to a higher risk of a recession, is if the curve inverts. That’s where longer dated bonds offer a lower yield than their shorter dated counterparts. This was briefly seen in US Treasuries back in March and has appeared before every US recession for the past 50 years.

Before we all turn and run, there’s an argument that the yield curves’ predictive powers have been muddied somewhat in recent years. That comes as central banks have pumped money into the system while buying their own bonds in the process, artificially impacting yields.

Nevertheless, paying attention to what’s going on in bond markets can help us understand how and why investments across a range of asset classes, like shares, are performing.

It can also give an overall indication as to how markets see economic conditions evolving over time. Of course, there are no guarantees market predictions are right.

Our research team covers a range of investments and keep a close eye on how the economy and markets are doing. Sign up now to receive expert insights straight to your inbox to help you get ahead.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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