Introduction to Bonds: The US 10-Year Treasury Note, a World-Wide Economic Indicator
One of the many ways firms and governments can finance their expenses is through the issuance of debt. When a company issues debt, it is called a corporate bond and in the case of a government, it can be called either a government bond or sovereign debt. Depending on the situation of the country or company, the debt instrument will have different risks and returns. One of the safest investments is the debt issued by the US government and this article will go into detail on one of the most important bonds; the 10-year US Treasury Note.
The 10-Year US Treasury Note is one of the four main debt instruments that the US government issues in order to finance itself. Amongst them, one can also find US T-Bills, T-Bonds and TIPS (Treasury Inflation-Protected Securities). These four types of bonds are issued by the US Department of Treasury and differ mainly in terms of maturity and coupon payments .
The 10Y T-Note has a maturity of ten years starting from the day of issuance. The investor will receive semi-annual coupon payments during the time to maturity and the full par value (principal value) once the ten years have passed .
When speaking about bonds, investors always refer to them either with the price of the bond or the yield to maturity (YTM) they will receive by buying the bond. The full price of a bond is called the par value or the principal value. This amount is returned to the investor at maturity. The yield to maturity of a bond, though, is the return the investor will achieve if the bond is held until maturity, with all payments made as scheduled and reinvested at the same rate . YTM is usually taken as a reference for investment decision-making.
Investors have easy access to the purchase of the 10Y US T-Notes. All debt instruments are issued electronically on the TreasuryDirect website: (Treasury Direct). Investors can only buy new bonds in the aforementioned website during the origination months: February, April, August, and November although there are reopening windows of these bonds every month. Nevertheless, an investor can choose to hold the bond to maturity or trade it in the secondary market. Unlike stocks, bonds do not usually trade in exchanges (such as NYSE or LSE). Most bonds are traded Over the Counter (OTC) .
As a result of everyday trading of bonds in the secondary market, bond yields suffer fluctuations due to supply and demand forces of the bonds, monetary policies, geopolitics, and other factors. Theoretically, the longer the maturity of a bond, the higher the yield will be. The reason being that as maturity increases, so does the period of time the investor spends without his/her money and consequently, risk of default also augments. This rule of thumb is reflected in what is called the yield curve, which depicts the yields of all the main debt instruments issued by the US Treasury. In a normal scenario, the yield curve would show an upward sloping trend, but this is not always the case. When bonds with longer maturity have lower yields than those of a shorter maturity, it is classified as an inverted yield curve. This means that investors predict a recession in the short term and thus, start buying longer-term bonds, such as the 10Y T-Note, as a safe haven asset. When demand for the 10Y T-Note increases, so does the price of these bonds. A rise in price implies a fall in yield . When the decrease in the yield of long-term bonds falls below shorter-term bonds, then the yield curve inverts showing an irregular trend. The yield curve is a barometer of sentiment and, historically an inverted yield curve is a notorious precedent of an upcoming recession.
For example, in March 2019, the US yield curve inverted as the 10Y T-Note yield slipped below the 3 Month T-Bill. This happened as a result of the Fed’s dovish stance over rate hikes and several disappointing news in Europe as well as the uncertainty surrounding the Brexit issue .
Why Is the Relevance of the 10-Year US Treasury Note So Powerful?
US Treasury bonds are said to be risk-free and in a certain way they are. The US Government has never defaulted in any principal value repayment to investors . The risks that revolve around US Treasury bonds are usually referred to as opportunity risks. What these risks basically imply is that the investor could have probably attained a higher profit with another investment. As it is known, the safer the investment is, the lower the rate of return will be .
The key to acknowledging the real importance of the 10 Year T-Note is to understand when and why the demand for this type of bonds rockets. The 10Y T-Note is known to be a safe haven asset and one of the most liquid securities. In other words, investors opt for this type of asset in times of market turbulence. Some other examples of safe-haven assets are gold and the 10-year German government bond, also known as the 10 Year Bund. For countries in the Euro area, the Bund serves as a benchmark to analyse the economic performance and risk of other bonds.
The 10 Year US Treasury Note is often labelled as a worldwide economic indicator for investor confidence. When confidence is high, the 10-year bond’s price falls and, oppositely, yields rise as investors feel they can achieve higher returns in other investments and have no need to play it safe. Inversely, when confidence is low, which normally happens in times of uncertainty or recession, the 10-year bond’s price rockets and yields fall .
Without doubt, what really makes the 10-year US T-Note world-renowned is its function as a benchmark for the assignation of interest rates of other financial assets. An investor that is looking to buy corporate bonds or mortgage-backed securities, for example, will use the 10-year bond as a yardstick to demand an appropriate interest rate, in terms of risk, credit rating and coupon payments .
Finally, the 10-year US Treasury Note is very often used for financial modelling and valuation. Many financial divisions, such as Investment Banking, Equity Research or Corporate Development, use the 10-year US bond yield as the market risk-free rate of return for the calculation of the WACC (Weighted Average Cost of Capital) .
Knowing This…, How Have Yields Been Affected by COVID-19?
In the chart below , one can see the Year to Date (29th May 2020) graphic of the yield to maturity fluctuations of the 10-year US Treasury Note. Following what has been explained previously, during times of unprecedented uncertainty and turbulence, investors tend to embrace safe-haven investments, such as the 10-year US bond. The 8th March 2020, the 10-year bond yield hit all-time lows of 0.318% during overnight trading and finally closed at 0.539% . This yield surged as a consequence of investors continuing to punish risky assets due to the uncertainty revolving around the virus as well as the fear of an all-out oil price war.
Moreover, the monetary policies adopted by Jerome Powell (chair of the Federal Reserve) to contain the extreme economic consequences from Covid-19, such as lowering interest rates by a whole percentage point to reach 0 – 0.25%, have also had a considerable and direct effect on the decrease of yields . Below, is another chart showing the current US yield curve compared to the yield curve a year ago which portrays the apparent decrease in yields as a general matter .
The future of bond yields will lie upon the development of the pandemic and the monetary and fiscal policies adopted by central banks and governments, respectively. Hopefully, the near future will lead the world economy to recovery and stabilization.