US Treasuries

The US Treasury yield curve has been inverted somewhere since 11/29, or 26 business days ago. If you’re reading and have any interest in finance, you’ve probably heard about this in hushed voices. This is why.

Interest rates follow something called a yield curve. The curve relates the interest rate to the duration among loans to a given credit quality. Bonds are loans. They have a few defining characteristics: maturity date, interest rate, value, and issuer are the biggies.

Working backwards, issuer is the entity that borrows the money. US treasuries are issued by the US government to finance the debt. The US federal government is the issuer or borrower.

The value, or face value, is specifically how much this bond is worth when it matures. The standard value is \$1,000, but treasuries may be purchased in any denomination up from \$25. Corporate bonds usually issue in higher denominations because this makes things cheaper for the issuer. As such, bond prices are talked about in relation to something called par or in terms of cents on the dollar. Par is the maturity value of a bond, but its discussed in terms of percent. So for a \$1,000 or a \$25 or a \$1,000,000, par is 100 (from 100%). Cents on the dollar goes the same way. It’s useful to talk about how prices move, because in percent, they move the same way for little and big bonds.

The interest rate is the interest the borrower pays the buyer to borrow the money. It is paid twice a year, and the final payment is paid concurrently with the bond maturing. In the real world this takes a day or two past the maturity date to settle. Sometimes this is called the coupon, but this terminology is obsolete. Old bonds had physical tear strips that were removed and turned into the bank for payment. Now it’s all electronic.

The bond comes due on the maturity date. The face value of the bond and the final interest payment, if any, are paid then. The time between now and the maturity date is the duration of the bond. So if I bought a Jan 1, 2020 bond in 2010, it was a 10 year bond then and is a 1 year bond now.

Take a simple example. The US government auctioned 9 year, 10 month bonds today, 1/9/2019. The CUSIP (which is the ID number for all of the bonds of one issue) was 9128285M8. These bonds mature Nov 15, 2028. This is pretty close to 10 years, so we call them 10 year bonds or notes.

The interest rate of the bond was 3-1/8% or 3.125%. So a \$1000 bond would pay \$31.25 a year in 2 \$15.625 payments. The last payment would be paid with the face value of the bond, for a final payment of \$1015.625. The 15th is a Wednesday, so it will probably hit your brokerage account by November 17th or earlier.

Here’s the trick. Bonds rarely sell for their face value. In 9128258MB, 103.398824 was the best (lowest) price. That’s in percentage, so \$1033.98824 for a \$1,000 bond. What this means is that actual yield, how much money the buyer or lender gets for the money isn’t exactly 3.125%. It’s actually 2.728%.

Now the price should be close to the value, but it varies a lot. When people particularly want bonds, the price goes up. The interest remains the same, so the yield goes down. When people don’t want bonds, the price goes down, but again the interest remains the same. The yield goes up.

In general people want bonds that mature sooner more, because we all want money now. The demand for long duration bonds is lower. So the yield of short duration bonds should be higher than long.

That’s not what’s happening now for all maturities. Treasuries that mature in about a year are yielding about 2.59%. 2yrs are at 2.56% and 3yrs are at 2.54%. Durations of less than 1yr are orderly, and yields go down as they get closer to zero. (1 month is as low as the official numbers go) Above 3 years yields go up as the duration gets longer. There’s just this little bit between 1 and 3yrs where instead of yield increasing with duration, it goes down.

People care for a few reasons.

1) Not all inversions precede recessions, but since the fifties, all recessions have been preceded by inversions. This could be a big warning sign.
2) It means people think investment prospects will be better in a few years than in 1 yr. This short term pessimism can lead to problems.
3) It may mean the Federal Reserve is raising interest rates too fast. The logic for this argument is beyond the scope of a blog post, and it’s something we like to yell and fight about in financial discussions. It’s like talking to a counter-shipper about your favorite ship, only less sex, less romance, and more money. Unless you ship Batman.
4) Actually, the Fed has more money than Batman. So think Darth Vader.

Does this matter?

I don’t know. I cannot see the future. But it is an interesting detail, and not all that’s worth knowing is worth doing something about. Put it in your brain hole.

Why are some people saying the yield curve isn’t inverted?

Because classically, we compare the 2yr and 10yr bonds. 10yrs are yielding 2.74%, which is comfortably more than 2.56%.

Why did you say 10yrs are yielding 2.74% but the example was 2.728%?

A bunch of math, and it demonstrates the point that these measurements aren’t exact. There’s some wiggle room here.