The 5% Problem

If you follow business news at all, it was hard to miss the blaring headlines last week as yields on 10-year Treasury notes went above 5%. This, together with falling stock prices, was widely greeted as a harbinger of tougher times to come for world markets. What's really going on?

The basics
Treasury notes are issued several times a year. They're denominated in multiples of $1,000 and sold to the public with a fixed coupon rate (sometimes called interest rate) that the U.S. Treasury sets. The note's owner receives an interest payment every six months, and at the end of the note's term, which can be two, five, or 10 years, it is redeemed for its face value (sometimes called par value, that multiple of $1,000). If you decide you want your money back earlier, there's a liquid secondary market ready and willing to buy your note.

Here's where things get a little tricky. Treasury notes almost never sell for their face value -- not when they're first sold to the public, and not in that secondary market. The initial selling price is set via an auction process, and prices in the market go up and down over time. The difference between the selling price and the note's face value makes up part of the note's yield. The yield simply tells you how much you'll earn if you buy a note at a particular price. As the note's price goes down -- as the discount from face value becomes greater -- the yield goes up.

The actual calculation can be complicated, but here's a simplified example: Suppose you're offered a Treasury note with a coupon of 4% that has a year left until maturity. Its face value is $1,000, and it's being offered at $990. If you buy it and hold it until the end of its term, you'll make $40 in interest (4% of $1,000) plus another $10 when the Treasury pays you the face value at the end of the term -- in other words, in one year, you'll make $50 on that $990 investment, for a yield of just over 5%.

Interest-ing market fluctuations
So now we know that yields go up when prices go down, which means that last week's high yields happened because investors were selling 10-year Treasury notes. Typically, this is an expression of concern about a possible rise in interest rates. Prices on lower-coupon notes fall when investors believe that the Treasury is going to issue higher-coupon notes in the near future -- the older notes have to sell at a discount to be competitive with higher-interest new notes -- and coupon rates rise and fall with interest rates.

And higher interest rates, of course, are stock market bulls' biggest fear right now. Most feel that the current bull market has been driven by global liquidity -- the low cost of borrowing money, particularly in certain countries, such as Japan. Borrowed money has funded the recent rash of acquisitions and private equity transactions, which have driven overall stock prices higher in two ways: by driving up prices on other companies that might be acquisition candidates, and by reducing the overall supply of stock in the market. Borrowed money has also funded a great deal of consumer spending, powering strong sales for everyone from Amazon (Nasdaq: AMZN  ) to Toyota (NYSE: TM  ) to Wal-Mart (NYSE: WMT  ) . Rising interest rates threaten to throttle down all of those growth engines, and thoughtful Fools will want to keep an eye on Treasury yields in the weeks ahead.

To learn more about Treasury notes -- and bonds of all kinds -- take a stroll through the Fool's Bond Center. And if you're interested in income investments, why not consider income-paying stocks? The Motley Fool's Income Investor newsletter provides easy-to-understand investment ideas for Fools. Why not help yourself to a free 30-day trial and start learning more (and earning more) today?

Fool contributor John Rosevear does not own any of the stocks mentioned in this article. The Motley Fool has a disclosure policy.

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