Technically, a treasury is a place where treasure is stored and may conjure up images of pirates, maps and desert islands. However, the term US Treasuries has a different significance.
A US Treasury is the term given to any debt obligation issued by the US federal government, usually by way of tradeable bonds. Investors investing in US Treasuries are lending their money directly to the US government and do so in the knowledge that it carries the highest credit rating of all worldwide investments of this type.
US Treasuries are a bell-weather for the state of the economy ebbing and flowing in response to leading and lagging indicators. Like almost all government bonds US Treasuries carry a nominal periodic coupon (interest rate) that is guaranteed. Should the circumstances of the investor change, the bond may be exchanged in the secondary markets. But how are the prices of a US Treasuries determined in these markets?
Outside of supply/demand factors and a bit of dealing greed the price determination is actually very arithmetic. Take a 10-year Treasury with a coupon of 5% as an example. If held to maturity the bond will repay 100% of the capital invested and will pay 5% annually over the 10 years. These “primary” conditions do not change. But what happens if the investor decides not to hold the Treasury to maturity and cashes in after 4 years?
Up to that point the original investor would have received 20% in coupons – leaving any subsequent investor with only 30% to collect for the remaining 6 years. It seems reasonable, therefore, that the original investor cannot demand a price for the Treasury that reflects 50% coupons (when there are only 6 x 5% left). All things being equal then, the price of the bond after 4 years should be cheaper than it was when it was issued – somewhat less than 100% – reflecting that some of the coupons have already been paid out and cannot be recovered.
Now let’s take a look at the deal from the second investor’s viewpoint. The Treasury will pay out a further 30% over 6 years and 100% at maturity. So the second investor will receive 130% over the 6 years having paid, for example, 99% for the investment. Accordingly, the actual return is more than 5% per annum. This return is referred to as the yield to maturity and, perversely, this is the reason why the bond yield rises when the cost of the bond falls.
(Over 6 years Investor #2 receives 100% + 30%) – Cost 99% = 5.20% yield approx.)
Bond traders will, undoubtedly, be very scornful of such over-simplifications and we fully accept that other factors play a part in price movements. It remains, however, the simplest way to understand the apparent paradox that bond yields are inversely correlated to bond prices. For the past 25 years global bond prices have risen relentlessly as yields have fallen. The great turning is at hand and investors should be duly prepared.