The 10-year U.S. Treasury yield jumped to its highest level in more than a year on Wednesday.
The yield, a benchmark commonly used to measure investors’ confidence in economic growth, has been steadily climbing since last summer. But recently, it’s risen at a more accelerated pace, topping 1.67% Wednesday morning.
“Overall, it’s not a negative thing to see rates rising,” says Matthew McKay, investment analyst at Briaud Financial Advisors based in College Station, Texas. “What’s spooked everyone is how fast it’s moved.”
Here’s what you need to know about the 10-year U.S. Treasury yield, and what it means for your portfolio.
What is the 10-year Treasury?
When you buy a bond issued by the U.S. government, you’re essentially giving Uncle Sam a loan. These Treasury securities include notes — often called T-notes — bonds and Treasury Inflation-Protected Securities (TIPS). Gone are the days of paper bonds; investors can now buy them directly through the Treasury’s website, or via a bank or broker.
T-notes are issued with two, three, five, seven and 10-year maturities in increments of $100. The owner earns interest every six months and when the T-note matures, the owner gets back the face value.
You don’t have to pay state and local income taxes on interest earned from these notes, but you do have to pay federal income tax. T-notes are also backed by the U.S. government, so they’re considered safe investments, as the government isn’t likely to default on its obligations.
Although these notes have a certain date at which they mature, investors don’t need to hold them to that date. You can sell them whenever you like to another buyer in what’s called the secondary market, which is how investment banks sell them to investors.
Enter yields. A T-note’s yield is its annual income divided by its current price. When demand is high, bidders pay more, resulting in a lower yield and ultimately, a lower return on your investment. The yield on the 10-year Treasury is watched closely, as it’s used to measure how confident investors are in the economy. When investors are scared, they flock to the perceived safety of Treasury notes and bonds, driving the bonds’ prices up and yields down; the reverse happens during an economic recovery.
What is going on with the 10-year Treasury yield?
The 10-year Treasury yield has been climbing since mid-2020, but recently the rise has accelerated.
That indicates that as the COVID-19 vaccine continues to be distributed, Wall Street seems optimistic about an economic recovery, says Jeffrey Hibbeler, senior portfolio manager at Exencial Wealth Advisors based in Huntersville, North Carolina. Some months back, when yields were lower, investors turned to other investment options like stocks to seek higher returns. More recently, the rise in yield levels is likely driving volatility in stock prices, he adds.
What is the 10-year Treasury telling us about inflation?
But the bullish sentiment for the economy comes with inflation concerns.
“The bond market typically is known as the smart market,” McKay says. For example, in the lead up to the Great Recession, the bond market was flashing red before stocks registered any sign of trouble. When Wall Street looks to the bond market to understand what is going on in the economy, a steepening of the long end of the yield curve — yields that are 10 years or more — indicates that inflation may rise.
Keep in mind that year-over-year inflation will rise either way, McKay adds. The beginning of 2020 saw such low economic numbers, and since there isn’t reason to think they will get any worse, we’re bound to see inflation rise as the economy recovers and prices pick up.
The question then, especially for long-term investors, is whether this inflation is lasting or not, and whether it will rise at a persistent, higher-than-average level. If it’s not lasting, we might see rates declining in the second half of the year.
Higher yields have fixed-income fund managers looking elsewhere, like to junk bonds and even stocks, the Wall Street Journal reported. That’s because high yields means lower prices for the bonds you own. Not every investor is in the same boat, though — retirees who depend on bonds for income, for example, want to see higher yields.
Average, well-diversified investors aren’t reliant on long-term bonds — they also own other asset classes, which would outperform in the same inflationary environment that’s weighing on bonds.
How can you protect your portfolio from inflation?
Another type of Treasury bond, TIPS, are one way to protect your portfolio against inflation. The amount the government repays the bondholder goes up and down with the consumer price index, so TIPS always maintain their “real” value, which takes inflation into account. The bonds’ interest payments, paid twice a year, are adjusted for inflation as well. In short: they’re designed to hedge against inflation, so they will often outperform other Treasury bonds during periods of high inflation. Money previously reported that exposure to this type of security could be as low as 1-2% if you’re a high-risk investor, or as high as 10% or more if you’re in retirement.
Commodities — natural resources like copper, crops and oil whose prices have been jumping recently — are another way to hedge against inflation. Historically, commodity prices have a high correlation with inflation, and investing in commodities can allow investors to profit off of those rising prices. Financial advisors tend to recommend choosing a diversified commodities ETF or mutual fund instead of picking commodities specifically. Having 5%-10% overall portfolio exposure to commodities could make sense, Money previously reported, with that number increasing for someone further from retirement and decreasing for someone in or near retirement.
Stocks can also be good hedges for moderate inflation, as typically earnings will increase as overall inflation increases, Hibbeler says. The recommended stock-bond ratio varies by age and risk tolerance, but some advisors say you can have up to 90% of your portfolio in stocks if you’re young and just starting your career, lowering that number the closer you get to retirement.