Yields rose as Federal Reserve policy makers prepared to meet on Jan. 28 to decide the next monetary step aimed at lifting the economy from recession. A government report due next week is expected to show the economy contracted last quarter for the second straight three-month period.
“Supply is probably the biggest story,” said Carl Lantz, an interest-rate strategist in New York at Credit Suisse Securities USA LLC, one of 17 primary dealers that trade with the Fed. “From here until we get the 30-year bond auction in the second week of February, there is a lot to get done.”
Thirty-year yields climbed 43 basis points on the week to 3.32 percent in New York, according to BGCantor Market Data. The gain was the most since bond yields increased 49 basis points in the five days ended April 24, 1987. The price of the 4.5 percent security maturing in May 2038 tumbled 9 25/32, or $97.81 per $1,000 face amount, to 122. The two-year note yield was up seven basis points on the week to 0.80 percent.
The benchmark 10-year note yield, used to set corporate borrowing costs and mortgage rates, rose 30 basis points, the most since increasing 35 basis points in the week ended June 13, 2008, to 2.62 percent.
5.5 Percent Contraction
Longer-term Treasuries sold off amid concern President Barack Obama will have to boost debt sales to help cushion an economy that contracted by 5.5 percent in the fourth quarter, according to the median estimate of 66 economists surveyed by Bloomberg News. The Commerce Department will release the report on gross domestic product on Jan. 30.
Obama pressed congressional leaders yesterday to reach a consensus on an economic stimulus plan expected to cost $825 billion, warning the U.S. may be facing an “unprecedented” economic crisis. The president said the legislation is “on target” for passage by mid-February.
Goldman Sachs Group Inc. on Jan. 22 raised its 2009 Treasury borrowing estimate to $2.5 trillion. The firm estimated the deficit this year at $1.4 trillion.
The Treasury will auction $8 billion in 20-year Treasury Inflation Protected Securities, or TIPS, on Jan. 26; $40 billion in two-year notes on Jan. 27; and $30 billion in five-year notes on Jan. 29.
‘Most Challenging Thing’
The government will likely sell $66 billion in three-, 10-, and 30-year securities next month in the Treasury’s quarterly refunding, equal to an estimated $62.5 billion in 10-year duration equivalents, according to David Ader, head of U.S. interest-rate strategy at Greenwich, Connecticut-based RBS Greenwich Capital Markets, another primary dealer.
“We’re facing the largest sale of 10-year equivalents ever with the refundings ahead,” Ader said. “Supply is going to be the most challenging thing we’ll have to deal with.”
Concern that supply will burgeon caused shorter-term securities to outperform longer-term notes and bonds this week. The difference between the yields on two- and 10-year notes grew by 21 basis points to 1.81 percentage points, the widest it has been since the week ended Dec. 12. The broadening came even as investors expected the gap to narrow with the prospect of the Fed buying longer-term U.S. debt, which policy makers have said they may do if long-term yields rise too much.
Selling ‘Overdone’
While this week’s sell-off was attributed to the large amount of supply expected, the rise in yields was “overdone,” according to Michael Pond, interest rate strategist at primary dealer Barclays Capital Inc. in New York.
“We are approaching the refunding period where we will get long-dated issuance, so its not surprising that it is weighing on investors’ minds,” Pond said. “Regardless, the economy remains weak and we do expect rates to remain low.”
Ten-year rates will fall to 2.42 percent by March 31, according to the median forecast of 62 economists in a Bloomberg survey. The 30-year yield will fall to 2.98 percent by the end of March, according to economists’ forecasts.
Yields also rose this week after Timothy Geithner, Obama’s pick for Treasury secretary, charged China is “manipulating” its currency, fueling concern foreign demand for U.S. debt may ease. A Chinese commerce ministry spokesman who couldn’t be identified under ministry rules responded yesterday, saying the country hasn’t manipulated the currency’s value.
Inflation Expectations
Thirty-year bonds have lost 9.3 percent this year as investors bet the government’s efforts to spur the economy by borrowing will ultimately lead to inflation, according to Merrill Lynch & Co.’s indexes.
“Historically, when we have seen supply and demand concerns arise it generally hits the long end more,” said Suvrat Prakash, an interest-rate strategist in New York at BNP Paribas Securities Corp., another primary dealer. “It is concern about the long term and how will the Treasury be able to keep rates low with so much issuance, but there are also arguments that it feeds inflation.”
The difference between rates on 10-year notes and TIPS, which reflects the outlook among traders for consumer prices, widened to a nine-week high of 73 basis points.
The so-called real yield, or what investors get from 10- year notes after inflation, reached a 16-month high of 2.55 percent. Consumer prices rose 0.1 percent for all of 2008, after increasing 4.1 percent the previous year, Labor Department figures showed.
More Bond Education
There are two fundamental ways that you can profit from owning bonds: from the interest that bonds pay, and from any increase in the bond’s price.Many people who invest in bonds because they want a steady stream of income are surprised to learn that bond prices can fluctuate, just as they do with any security traded in the secondary market.
If you sell a bond before its maturity date, you may get more than its face value; you could also receive less if you must sell when bond prices are down. The closer the bond is to its maturity date, the closer to its face value the price is likely to be.
Though the ups and downs of the bond market are not usually as dramatic as the movements of the stock market, they still can have a significant impact on your overall return. If you’re considering investing in bonds, either directly or through a mutual fund or exchange-traded fund, it’s important to understand how bonds behave and what can affect your investment in them.
The price yield see-saw and interest rates
Just as a bond’s price can fluctuate, so can its yield - its overall percentage rate of return on your investment at any given time. A typical bond’s coupon rate, the annual interest rate it pays, is fixed. However, the yield isn’t, because the yield percentage depends not only on a bond’s coupon rate but also on changes in its price.
Both bond prices and yields go up and down, but there’s an important rule to remember about the relationship between the two - they move in opposite directions, much like a see-saw. When a bond’s price goes up, its yield goes down, even though the coupon rate hasn’t changed. The opposite is true as well: When a bond’s price drops, its yield goes up.
That’s true not only for individual bonds but also the bond market as a whole. When bond prices rise, yields in general fall, and vice-versa.
What moves the see-saw?
In some cases, a bond’s price is affected by something that is unique to its issuer - for example, a change in the bond’s rating. However, other factors have an impact on all bonds. The twin factors that affect a bond’s price are inflation and changing interest rates. A rise in either will tend to cause bond prices to drop. Inflation and interest rates behave similarly to bond yields, moving in the opposite direction from bond prices.
If inflation means higher prices, why do bond prices drop?
The answer has to do with the relative value of the interest that a specific bond pays. Rising prices over time reduce the purchasing power of each interest payment a bond makes. Let’s say a five-year bond pays $400 every six months. Inflation means that $400 will buy less five years from now. When investors worry that a bond’s yield won’t keep up with the rising costs of inflation, the price of the bond drops because there is less investor demand for it.
Why watch the Fed?
Inflation also affects interest rates. If you’ve heard a news commentator talk about the Federal Reserve Board raising or lowering interest rates, you may not have paid much attention unless you were about to buy a house or take out a loan. However, the Fed’s decisions on interest rates can also have an impact on the market value of your bonds.
The Fed takes an active role in trying to prevent inflation from spiraling out of control. When the Fed gets concerned that the rate of inflation is rising, it may decide to raise interest rates. Why? To try to slow the economy by making it more expensive to borrow money. For example, when interest rates on mortgages go up, fewer people can afford to buy homes. That tends to dampen the housing market, which in turn can affect the economy.
When the Fed raises its target interest rate, other interest rates and bond yields typically rise as well. That’s because bond issuers must pay a competitive interest rate to get people to buy their bonds. New bonds paying higher interest rates mean existing bonds with lower rates are less valuable. Prices of existing bonds fall.
That’s why bond prices can drop even though the economy may be growing. An overheated economy can lead to inflation, and investors begin to worry that the Fed may have to raise interest rates, which would hurt bond prices even though yields are higher.
Falling interest rates: good news, bad news
Just the opposite happens when interest rates are falling. When rates are dropping, bonds issued today will typically pay a lower interest rate than similar bonds issued when rates were higher. Those older bonds with higher yields become more valuable to investors, who are willing to pay a higher price to get that greater income stream. As a result, prices for existing bonds with higher interest rates tend to rise.
Example: Jane buys a newly issued 10-year corporate bond that has a four percent coupon rate - that is, its annual payments equal four percent of the bond’s principal. Three years later, she wants to sell the bond. However, interest rates have risen; corporate bonds being issued now are paying interest rates of six percent. As a result, investors won’t pay Jane as much for her bond, since they could buy a newer bond that would pay them more interest. Later, if interest rates begin to fall, the value of Jane’s bond would rise again - especially if interest rates fall below four percent.
When interest rates begin to drop, it’s often because the Fed believes the economy has begun to slow. That may or may not be good for bonds. The good news: Bond prices may go up. However, a slowing economy also increases the chance that some borrowers may default on their bonds. Also, when interest rates fall, some bond issuers may redeem existing debt and issue new bonds at a lower interest rate, just as you might refinance a mortgage. If you plan to reinvest any of your bond income, it may be a challenge to generate the same amount of income without adjusting your investment strategy.
All bond investments are not alike
Inflation and interest rate changes don’t affect all bonds equally. Under normal conditions, short-term interest rates may feel the effects of any Fed action almost immediately, but longer-term bonds likely will see the greatest price changes.
Also, a bond mutual fund may be affected somewhat differently than an individual bond. For example, a bond fund’s manager may be able to alter the fund’s holdings to minimize the impact of rate changes. Your financial professional may do something similar if you hold individual bonds.
Focus on your goals, not on interest rates alone
Though it’s useful to understand generally how bond prices are influenced by interest rates and inflation, it probably doesn’t make sense to obsess over what the Fed’s next decision will be. Interest rate cycles tend to occur over months and even years. Also, the relationship between interest rates, inflation, and bond prices is complex, and can be affected by factors other than the ones outlined here.
Your bond investments need to be tailored to your individual financial goals, and take into account your other investments. A financial professional can help you design your portfolio to accommodate changing economic circumstances.
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