Bonds, the Yield Curve, and Recession Indicators - Part I: Bonds

Okay, I want to address some fallacious notions about what the Treasury yield curve tells us about the likelihood of a future recession and how "imminent" one might be, as well as some related topics about recession indicators. But first, I need to explain what the yield curve is, and why it looks the way it does at various times. (Technically, I'll be addressing the theories behind the term structure of interest rates, but don't get hung up on that - that sounds very technical, but it's pretty straightforward. Just think of it as, "Why does this graph look like this, and what is it telling me?")

Before I talk about the yield curve, I need to briefly discuss bonds. We're going to take all this in three installments, so as to not overwhelm. For today, we'll just stick with bonds.

Bonds are basically loans - they're obligations to repay money at some point in the future, with interest. Ford Motor borrows money from investors by issuing bonds that investors then purchase (those are corporate bonds, because they're issued by a corporation). The bond is a promise to repay the money. The bond has a maturity - for example, there's a currently outstanding Ford Motor Co. bond with a maturity date of Jan. 15, 2043. It was issued in Jan. 2013, so it was originally a 30-year bond. Thus, Ford was borrowing money for 30 years. The interest rate, or coupon, is 4.75% per year, paid every six months, with the principal paid at maturity. If you bought $10,000 of that issue, you'd get $237.50 every six months (4.75% x $10,000 / 2, since the interest rate is annual and you're getting paid semi-annually), and at maturity you'd get $10,237.50 (your principal back, plus the final coupon payment).

For now, we won't get into structured bonds like callables, or variable-rate bonds, or mortgage-backed bonds. So it's pretty straightforward: you get periodic interest (coupon) payments, and principal at maturity.

Bond market joke: What's the difference between men and bonds? Bonds mature.

Municipal bonds work the same way, except they're issued by municipalities (cities, counties, etc.) to fund schools, roads, libraries, etc. (In many cases, the interest investors receive is tax-exempt, but don't worry about that for our purposes.)

Corporate and municipal bonds carry ratings assigned by ratings agencies like S&P, Moody's and Fitch, based on the creditworthiness of the issuer, or borrower. It's like their credit score, and as with a credit score, the lower the rating (i.e., the less creditworthy the issuer), the higher the coupon. For example, AA-rated corporate bonds (a high rating) currently yield about 4.45%. BBB-rated corporate bonds (the lowest investment-grade rating; anything rated lower is considered a "junk" bond) yield 5.44%. The investor is taking on more risk that the less creditworthy borrower could default at some point before the bond matures, so he should get compensated more for that risk.

U.S. Treasury bonds also work the same way, paying interest every six months and principal at maturity. (Shorter term instruments called Treasury bills work differently, but we're not going to talk about them.) They carry the highest possible rating, because they're backed by "the full faith and credit of the U.S. government." Meaning that the government will always pay the interest and principal, because they can just tax us all to the deuce and back to get the money to do so. Because of their perceived high credit quality, their yield is lower than corporate bonds; currently, the yield on the 30-year U.S. Treasury bond is about 3.75%, or about 70 basis points (bp) less than a high-rated corporate bond of similar maturity (recall that a basis point is 1/100th of a percent).

In fact, all other bonds are priced off Treasury bonds; the yield on Treasuries is known as the benchmark, and the difference between the Treasury yield for a given maturity and the yield on corporate or municipal bonds of equal maturity is the spread. (There are other types of bonds besides the structured varieties I mentioned, most notably agencies, which are issued by various government entities, but again, that doesn't matter for our purposes - it's just informational.)

Let's talk about yield for a minute. The coupon is the stated interest rate on the bond; it determines the amount of the periodic interest payments. In our Ford Motor example, the coupon was 4.75%, and the reason we got $237.50 every six months on our $10,000 investment was a function of the coupon times the principal amount, divided in half due to the payments being made twice a year.

The yield is a function not only of the coupon, but, to a larger extent, the price paid for the bond. If the price paid is par (100 cents on the dollar), the yield will equal the coupon rate. If the price paid is more than par, the yield will be less than the coupon rate, because the investor paid more than he's going to get back at maturity, and that offsets the coupon interest to a degree. If the price paid is less than par, the yield will be higher than the coupon rate, because the investor paid less than he's going to get back at maturity, so the "gain" at maturity is added to the coupon rate to produce the yield.

A simple example is that an investor might, due to prevailing market conditions, pay $11,000 for that Ford Motor bond, and only get $10,000 back at maturity. Or, he might pay $9,000 for the bond, and he'll still get $10,000 back at maturity. The investor always receives par at maturity, except in the case of some structured bonds. (I'd give a more detailed example, but I'd have to show you the yield calculation, and I don't want to burden you with that.) We'll discuss why an investor might pay more or less than par for a bond in a few paragraphs.

I've noted this before, but it's important to remember that as bond prices go up, bond yields, and thus market interest rates in general, go down, and vice versa.

Now let's talk about Treasury bonds in more detail. Because they're so highly rated, investors prefer them for safety. For that reason, any time there's a significant event that spooks investors, they flood money into Treasuries. As a result of all that purchasing demand, the price of Treasury bonds goes up that day, and thus the yield goes down.

That's known as a "flight to safety" or "flight to quality."

Now, I recently read an opinion on social media that a daily change of about 8bp on the ten-year U.S. Treasury note (we'll talk about the various maturities when we discuss the yield curve) was "huge," and that bonds "normally move in very small increments."

This simply isn't true. There have been considerably larger moves in the ten-year note yield in the past several years: in March 2022 (related to the Ukraine invasion by Russia), in November 2022 (related to an unexpected inflation print), and back in September 2021 (related to a large move in stock prices). The recent 8bp move was related to irrational fears, spread by the media, over systemic risk in the U.S. banking system, which produced another flight to safety as investors shed bank stocks.

Flights to quality are not that uncommon, especially with the media sensationalizing everything and "experts" on social media spreading rumors and conspiracy theories left and right. But an 8bp drop in the 10-year yield (or even an 18bp drop in the 2-year yield, which happened the same day) is far from unprecedented, or even abnormal. If you wanted to see big changes in Treasury yields, you should have been around the bond market in 2008-09.

While it's true that the average daily change (up or down) in the 10-year yield, since 1962, has been about 4.3bp, the daily change has exceeded 8bp nearly 1,000 times since 1000 alone. Thus far in 2023, it's exceeded that amount more than 30 times. And the 2-year yield has changed by more than 18bp eleven times this year alone. The point of this is that large daily moves in bond yields are not uncommon, and I don't want anyone to be misled into thinking that they are. It happens fairly regularly, for a variety of reasons.

To close out today's discussion, we'll look at the different maturities of U.S. Treasury debt:

• 1-month Treasury bill, or T-bill
• 3-month T-bill
• 6-month T-bill
• 1-year T-bill
• 2-year Treasury note
• 3-year Treasury note
• 5-year Treasury note
• 7-year Treasury note
• 10-year Treasury note
• 20-year Treasury bond
• 30-year Treasury bond

The various maturities are auctioned periodically to issue new debt. Issues that have already been sold into the market at auction are said to be "trading secondary," or trading in the secondary market (as opposed to the new issue or auction market). The price at auction is fixed at par according to prevailing market rates; the price of secondary issues fluctuates as market rates change relative to the bond's coupon.

Don't get hung up on this, but here's an example. Let's say a 10-year note is issued at par (100 cents on the dollar) with a coupon of 4.00% in October, 2008, because that's what the market yield on the 10-year was then. A couple of months later, in December 2008, an investor wants to buy that note in the secondary market. He's going to have to pay a lot more than par. Why?

Because the prevailing yield, or rate, on the 10-year note in December had plunged to just over 2% (remember what I said about big swings in the bond market in 2008-09?), so to receive 4% interest payments every six months in a 2%-yield market, he's going to have to pay a premium. (The amount paid above par is called the premium; it's necessary to bring the yield - which again is a function of the coupon payments and the price paid - in line with prevailing market yields. You pay more up front, which reduces your return, since you only get par back at maturity. But you get 4% interest, when the market is at 2%. So your yield is 2%; the 4% coupon interest is reduced by the premium you paid up front.)

Conversely, let's say the same investor buys a newly issued 10-year note in December 2008, which would have a coupon of about 2%, since that was the prevailing yield. He goes to sell it six months later, in June 2009, when the 10-year yield is back up to around 4% (there are those big swings again!). Now, to get the buyer to accept a 2% coupon in a 4% market, he has to sell the note for less than par, or at a discount (the discount is the amount paid less than par). The buyer's return, or yield, is 4%; the 2% interest is supplemented by the fact that the buyer pays less than par at purchase but gets the full par amount back at maturity.

If all that is as clear as mud, like I said, don't get hung up on it. It's not that important for our subsequent discussions. For now, the main focal points are these:

1. When bond prices go up, yields go down, and vice-versa
2. The Treasury market consists of the 11 maturities listed above, which make up the term structure of the yield curve (we'll introduce and illustrate that in the next installment)
3. Besides the bills, the most important maturities are the 2-year, the 5-year, and the 10-year; we'll explain why in the next installment.

A final point: for our purposes, we'll be using the term "bonds" to describe both notes and bonds. They all make up the bond market.