Please ensure Javascript is enabled for purposes of website accessibility

The 5% Problem

By John Rosevear – Updated Mar 7, 2017 at 1:47PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Treasury yields are up. What does it mean?

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.

None

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Walmart Stock Quote
Walmart
WMT
$130.06 (-2.50%) $-3.33
Amazon.com, Inc. Stock Quote
Amazon.com, Inc.
AMZN
$113.78 (-3.01%) $-3.53
Toyota Motor Corporation Stock Quote
Toyota Motor Corporation
TM
$137.28 (-1.27%) $-1.77

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
329%
 
S&P 500 Returns
106%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 09/24/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.