Rising bond yields are wreaking havoc in the market, specifically the stock market. Before discussing why bond yields are rising, let’s look at some definitions and some basic rules of bonds.
What is a bond?
A bond is simply debt. It’s a loan from you to a company or government. Governments use treasury bonds to borrow money from individuals and institutions. In return for buying the bond, they pay you interest(yield) each year for a fixed period(e.g. 10 years). When this period ends, they pay you back the full amount of the bond.
What is a bond yield?
A bond yield is the return an investor gets for holding a bond. It is calculated by dividing the interest the bond pays by the price of the bond as a percentage.
For example, if you buy a $1000 bond that pays an interest of $100, the bond yield is 10% calculated by:
10% => ($100 / $1000) * 100
The Basic Rule of Bonds
The most important rule of bonds is: when bond prices rise, bond yields fall.
Let’s say the price of your bond rises to $1200. The yield will fall to 8.3%. Here’s the calculation:
8.3% => ($100 / $1200) * 100.
So, Why are Bond Yields Rising?
Here are four reasons why bond yields are rising:
1. Strong Economic Growth
Bond returns are currently less than 2%. During a robust economic growth, other investments offer better returns than the bond market. The stock market, for example, has had an average yearly return of 10.20% since 1926.
The economy is expected to experience strong growth in 2021 following widespread vaccinations and the reopening of economies. Investors are eyeing better opportunities in the stock market, with company earnings getting better and better into 2021 due to strong economic growth.
- Related: The State of The Economy 2021
A massive stimulus package has recently been rolled out. Pray tell how the government raises money to fund stimulus cheques. They sell treasury bonds to individuals and institutions. So there are more bonds in the market for sale which means that the law of supply and demand kicks in. When the supply of bonds is high, their prices drop. Going back to the first rule of bonds, when the price of bonds falls, yields rise.
The Fed expects inflation to rise to about 2.2% by the end of 2021. And as mentioned earlier, bond yields are currently meager at less than 2%. If inflation does occur at 2.2%, the real returns on bonds will be negative (2.2% -2% = -0.2%). Bonds are therefore not appealing to investors at the moment. This causes a decrease in demand, pushing the prices lower and raising bond yields higher.
4. Interest Rate Hikes
Central banks combat inflation by raising interest rates. Due to the generous stimulus package by governments, fears of inflation are growing among investors. And even though the Federal Reserve is determined not to raise interest rates until 2023, investors are afraid that raising interest rates will be imminent due to high inflation.
Therefore, investors are not interested in buying bonds at the moment and are waiting for interest rates to go high to get better returns on their bonds. As a result, demand for bonds is decreasing, causing prices to fall and consequently prompting bond yields to rise.
What it Means for Your Investments
Even though the Federal Reserve has reiterated that rising bond yields should not be a cause for concern, the stock market still reacts negatively to the slightest news of a rise.
There seems to be immense fear in the market that’s causing panic selling. Its however important to remember that corrections never last too long.
The best thing to do at this point is to:
- Stay calm
- Do not panic sell
- Buy the dip
To learn more about how bond yields affect the stock market, check out this article on why the stock market is crashing.
As mentioned, the four main reasons why bond yields are rising are:
- Projections of strong economic growth
- Stimulus package
- Fears of Inflation
- Anticipation of interest rate hikes