In 1785, The Congress of the Confederation agreed that a decimal denoted dollar would be the official currency of the United States, Napoleon Bonaparte became a lieutenant in the French artillery, Louis XVI signed a law that all handkerchiefs must be square, and the University of Georgia was chartered, becoming the first state-chartered university in the United States.1
Monday, January 10, 2022, The University of Georgia Bulldogs defeated the Alabama Crimson Tide in the NCAA College Football Championship. This is the first National Championship win for UGA since the season of 1980 when they defeated Notre Dame in the Sugar Bowl with the help of a freshman running back, Herschel Walker.
If you purchased a 10-year U.S. Treasury note after the Bulldogs last National Championship (January 1981), you would have been promised 12.42% for 10-years – $12,420 annually on $100,000. A few months later, in September, the yield on the 10-year reached 15.84%.2
Late September 1981 marked the highest point in U.S. Treasury rates since they have been tracked. Since that point, over forty years, we have predominately been in a falling or stable interest rate environment. The 10-year Treasury yield touched a low of 0.52% in August 2020 and has risen since – currently just under 1.8%.
Fixed Income investments are straightforward; they are contracts. A company or government borrows money from the public with a promise (not guarantee) to pay it back. Most bonds are issued with face values in $1000 denominations and pay a fixed annual interest payment for a fixed period. That said, when it comes to a rapidly changing interest rate environment, it can become a little confusing. A colleague refers to bonds as “math investments.” Because they are fixed-income contracts, we can usually apply math to better understand what is happening.
There are three main rates that can be applied to a bond or note, coupon, current yield, and yield to maturity [or call]. A single bond will have all three rates at the same time.
- Coupon – the interest rate on the bond when issued. A bond issued at $1000 that pays $50 annually has a coupon of 5%.
- Yield to Maturity – the discounted cash flows of the remaining payments utilizing current market interest rates. While the maturity value of the bond, maturity date, and annual payment all stay constant, prevailing market interest rates can and do change over the life of a bond.
- Current Yield – the annual payment divided by the current market price. An annual payment of $50 on a bond that is trading at $800 equates to a current yield of 6.25%.
The above-mentioned 1981 10-year 12.42% coupon note would have reacted to the increasing rate over the next nine months by experiencing a decline in market value.
The maturity value must remain $100,000 and the annual payment must remain at $12,420. The only factor that can change is the market price of the note, it must come down to a point where the yield to maturity will be closer, if not equal, to the then-current market rate of 15.84%. This equates to an approximate market price for the note of $83,700. At that price, the current yield would have been 14.84%.3
If we wanted or needed to sell the Treasury note at that point, we would likely receive a significant discount of around $83,700 (present value of remaining payments assuming the increased market yield) on our initial investment of $100,000. But… if we ignored the market price and held the note to its 1991 maturity, we would have received payments of $124,000 ($12,420 X 10 years) and the return of our $100,000 investment.
Rates could be stable or even go down from our current level, however, the Federal Reserve has a stated goal to increase rates over the next couple of years.4 If they are successful, we would expect to see a decline in the market price of existing fixed income positions.
The math behind bond yields and pricing logically explains what is happening, but it can still be understandably alarming to see declines in the market value of fixed-income investments. To the degree our clients utilize bond investments, especially to rely on current income, we have been repositioning to commercial real estate investment in replacement of fixed income to reduce volatility, enhance current income, and benefit from tax advantages associated with real estate investments.
Please let me know if you would like to discuss college football, bond pricing, or anything else on your mind.
1 1785. Sourced from – https://en.wikipedia.org/wiki/1785
210-Year Treasury Rates. Sourced from – https://www.macrotrends.net/2016/10-year-treasury-bond-rate-yield-chart
3 Bond YTM Calculator. Sourced from – https://dqydj.com/bond-yield-to-maturity-calculator/
4 Fed officials discussed raising rates sooner and faster in 2022. Sourced from – https://www.nytimes.com/2022/01/05/business/economy/federal-reserve-minutes-interest-rates.html