American consumers are familiar with the concept of debt. In prior generations, people simply did without – homes, vehicles, college etc. Today, however, debt is a thing to be carefully managed. In so doing, we can afford things when we pay for them over a period of time. The government engages in this practice. Investors buy federal debt as Treasury bonds, receiving profit from interest they yield. How those yields perform in the market is called a treasury yield curve.
How Investors Obtain Treasury Bonds
Investors can purchase Treasury bonds from a choice of outlets: brokers, banks, dealers or the U.S. Treasury itself. In addition, buyers have the option of purchasing competitively or non-competitively. With the latter, the investor simply accepts whatever yield (interest rate) is determined at auction. The advantage here is that the financier will get the desired bond in the desired amount. A competitive bid, by contrast, has the investor dictating the acceptable yield. Under this scenario, the buyer might not get the bond, at least not in the requested amount. A high yield on little money may not be worth it.
How Yields Earn Money
Because they are backed by “the full faith and credit of the United States government,” Treasury bonds (or bills, or notes) represent safe, conservative investments. When a financier buys one of these instruments, he or she (or the legal entity) becomes a creditor to the government. When the Treasury makes payments on its debt, it includes interest to the creditor – an amount known as a coupon.
Bonds, bills and notes differ primarily in their respective terms of maturity. T-bills are the shortest, often maturing in a year. T-notes can take 10 years whereas T-bonds range between 20 and 30. As an aside, buyers purchase T-bills below face value, so their profit comes when the bill is paid in full as opposed to coupon income. Holders of T-bonds and T-noted receive coupon payments twice a year.
How Does the Curve Affect Treasury Income?
The Treasury yield curve, at its simplest, is a graphic demonstration of the relationship between yield and maturity for on-the-run (most recently issued) securities. In other words, how much are government bonds yielding at seven years, 10 ears, 15 years etc? Accordingly, the Treasury yield curve also goes by the description, “term structure of interest rates.” The shape of this curve suggests how investors are feeling about bills, notes and bonds into the future. The vertical axis represents the yield as the horizontal stands for term length.
So, for instance, under normal economic conditions, longer term securities pay better than their short-term counterparts. The government pays its creditors more for the privilege of keeping money for a greater amount of time. Here, the curve slopes upward from left to right. Yet circumstances can change the shape of the curve. When economic volatility emerges, the curve can go flat: long-term debt pays no better than short-term. Unfortunately, the Treasury yield curve sometimes follows the flat line with an inverted curve, signifying the diminishing profitability of long-term bonds.
What Sort of Factors Influence the Treasury Yield Curve?
Perhaps the most direct impact on the Treasury yield curve is from changes in the interest rate. In response to the 2008 financial crisis, for example, the Federal Reserve Board of Governors slashed key interest rates, i.e. the discount rate and the federal funds rate. In so doing, banks and other lending institutions felt safe in lowering their own rates. Although mortgagors and other debtors would applaud such measures, investors in debt saw reductions in their yields. In this instance, the 10-year Treasury bond dropped from a five percent yield to less than three percent.
Inflation is another determinant relative to the Treasury yield curve. On the one hand, interest rates are cut when the Fed seeks to spur economic growth. On the other, the central bank will hike interest rates if it sees or anticipates inflation. Generally identified by increasing prices of products and services, along with the decreasing purchasing power of money, inflation wrought havoc on the U.S. economy in the 1970s. Eager to prevent high inflation rates, central bankers see interest rates as a means of reducing the money in circulation, thereby increasing its value.
Consequently, inflation – or its specter – is a precursor to higher rates for borrowers and greater yields for investors. In so doing, it indirectly restores the Treasury yield curve to an upward slope. Of course, that which is good for the overall economy is not always profitable for long-term bond holders.
It is hard to oppose a concept so promising as economic growth. It often means increased production and stronger demand. Gross Domestic Product increases and capital investment flourishes. Again, though, when an economy heats up, Treasury products are less attractive to financiers. A big reason for this is the stock market–its offerings get more competitive as business investment flourishes. Profits from dividends eclipse yields and the curve thus takes a turn.
This can sometimes spell trouble, however, when an economy heats up. When the yield curve reaches the point of inversion – short-term Treasuries out-performing long-term bonds – it can be a harbinger of recession. In fact, the last seven recessions were preceded by just such an indicator. Those managing an economy must be careful to monitor the rate of growth lest it swing the other way unexpectedly.
As we can see, the treasury yield curve is both a thermometer and thermostat. It can reveal certain realities, predict particular futures and influence economic decision-making. Investors in the bond market recognize that the better things look for longstanding bonds, the less appealing other investments can be. The opposite, of course, is also true. If the behavior of the yield curve teaches anything, it instructs us to diversify our financial investments.