Bond Yields Primer: Recognizing the difference between price and value

When yields decline, bond prices increase. The fact that prices are increasing means that there is more demand for those bonds. In other words, people are buying more bonds than before. As more people buy, price pressure increases and therefore bond prices rise. The question then becomes why people buy: many buy because some underlying belief about the future – irrespective whether that underlying belief is grounded in sound analysis or not. Others buy because they are mandated by their institutions (e.g. bond funds, pension funds, FRB open market operations). When we focus on those buyers who have a negative view of future economic activity, they will de-risk their investment portfolios and move to more liquid and less risky investments, such as bonds. In other words, money is leaving some other non-bonds market and entering the bond market. As more money rushes in, bond prices rise and bond yields decline. The reserve is also true: when yields increase, bond prices decline. Price declines mean people are selling bonds and purchasing other assets because in their view they believe other assets are more attractive (this trade-off is what economists call Opportunity Cost).  

When we look at the recent trend in the Treasury bond market we see a general widening of spreads (i.e. difference) between longer tenor (i.e. maturity) bonds and shorter tenor bonds. For example, the difference between the 3-month yield vs. the 10-year yield stood at 0.84% on 12/31/20, and it is now (as of 2/19/21) at 1.3%. In this instance, the yield for the 10-year bond has been increasing (from 0.93% to 1.34%; bond prices declining) and the yield for the 3-month Note has been declining (from 0.09 to 0.04; prices increasing). In other words, people are selling the 10-year bond (or decreasing the rate of purchase) and buying the 3-month Note at a faster clip.  

The increase in yields means money is leaving the US Treasury market and going somewhere else. Some of it is going to the shorter end of the Treasury curve, and some of it is going to other financial markets. At this time and in this context, this dynamic is being perceived as positive for market participants who hold riskier assets. However, it can also mean that the increasing yields are representative of a rate of market malinvestment (i.e. bad decisions increasing). I think the case for the latter point is more appealing. Market reversals tend to be poignant and sudden. Caveat emptor.