The bond market has gained a lot of attention in 2022 as yields have started to climb gradually. The U.S. 10-year bond yield in early January 2022 was at 1.67% and as of June 23, it had increased to 3.06%. This bond yield is close to the highest figure in the past four years. The question investors now ask is whether it is better for bond yields to go up or down. The answer is given below based on three arguments.
The main idea to consider is that bond yields reflect the riskiness of the economy and the expectations about its prospects and strength.
Bonds Signal the Strength of the Economy
Imagine for one moment that you want to invest in bonds, and you can choose among debt issued by either countries or companies. Country A has bonds with a yield of 5%, country B offers 1%, and country C offers a high yield of 10%. Bond investing is about finding the sweet spot between risk and return. Country C offers the highest bond yield for two main reasons. It is a riskier economy than country B and country A. As such, it must offer a high yield or a return to buy and hold its bonds; otherwise, it will not be able to raise capital.
Country A is the safest economy among all countries, and it just needs to offer a low bond yield to attract foreign and local investors to invest in its bonds. Country B’s economy is neither too strong or weak. Rather, its economy does not yet perform as it should to be considered strong. It needs plenty of time for more growth, and to lower its total debt level.
The U.S economy in this example would be country A. However, with a high and persistent inflation things have changed dramatically.
Bonds Indicate Investor Confidence
Bonds compete with stocks to attract daily capital in the global financial markets. Back in 2020, the 10-year bond yield was very low nearly at 0.60%, and at one time it was nearly 0.54%, so bonds were not attractive as the stock market (after the pandemic-induced crash) started rallying. Investors had no desire to invest their money in bonds to earn a 0.60% return. They preferred high-risk stocks with high returns.
Now, as bond yields have risen, and will rise more as the Federal Reserve increases interest rates further, investors feel nervous about the stock market. The valuation of equities has declined and there are fears of an upcoming recession.
Bonds now offer higher yields, and they’re considered safer financial assets than stocks as investors make a switch to safety. Imagine the scenario of the 10-year bond in the U.S. reaching 5%. This is a decent return for a low-risk financial asset, and several risk-averse investors will prefer to invest in bonds rather than in stocks now.
With that in mind, it is important to examine the bond yield curve. Under normal economic conditions, long-term bonds should have higher bond yields than short-term bonds. An inverse phenomenon often raises concerns about the health of the economy.
Should a Strong Economy Have Low or High Bond Yields?
Government bond yields reflect the cost of money to invest in these risk-free assets. Inflation is a catalyst to monitor as it can push bond yields higher and derail the true economic growth and potential of the economy. As low bond yields reflect a safe and strong economy and the cost of money to borrow is rather low, it is best to have low bond yields than higher ones.
Higher bond yields also mean that economic conditions have worsened, as companies should want to raise debt and should offer a higher yield than government bonds so that investors find corporate bonds attractive investments. Under these conditions, companies will have to pay more to investors, which will increase their interest payments and harm profitability.
It’s undeniable that bond yields are rising in the U.S. market due to high inflation and higher interest rates, which is bad news in general. As such, we should embrace for plenty more turbulence in the U.S. economy throughout 2022.
On the date of publication, Stavros Georgiadis, CFA did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.