A Primer on United States Treasuries
How do they relate to other assets?
A few years into my career, I came to the realize that most investment markets, especially those most regular people invest in (equities), have strong relationships to the United States Treasury (UST) market.
Considering the recent moves in that market, I want to explain what the UST market is and how it relates to equities, loans and other investments.
A United States Treasury is a debt obligation backed by the full faith of the United States government. Anyone can buy a United States Treasury, but they are primarily purchased by institutional investors and governments. Today, USTs are considered the safest investments in the world.
One of the most common United States Treasuries cited by the media / markets is the UST 10 year bond. Today, an investment in the UST 10 year bond will yield you about 1.5% per year. This means that if you invest $1,000, you will get $10.50 a year until it matures in 2031 and you get your $1,000 back.
You can buy treasuries that mature in most months and many different years, but only a select few are tracked by the markets, and are the reference rates that are used by the markets to drive expectations and investment decisions.
So how do other investment assets relate to USTs? It is important to note that the relationships I am about to explain are just one input in determining the price of the assets in question. These relationships do not always hold. Treasury rates affect not only the asset classes below, but many other asset classes and financial instruments such as commodities, futures, and options.
Foreign Exchange
All else being equal, when UST rates are rising across the board, it means that the United States dollar will strengthen, assuming that rates in the foreign currency in question are stable or dropping. For example, if UST rates are rising, and Canadian Government Bond rates are falling, the US Dollar will get stronger versus the Canadian Dollar. This is simply because as rates rise, it becomes more attractive to purchase United States Treasuries. Therefore major market participants would find it appealing to sell their Canadian Government Bonds, sell Canadian Dollars for US Dollars and buy USTs.
Corporate Fixed Income Securities
The simplified version of obtaining the yield for a fixed income security is benchmark rate + credit spread. In the case of US dollar denominated corporate bonds, the benchmark rate is the UST that matures closest to the corporate bond. For example, a 5 year Wal-Mart bond would have a yield of 0.80% (5 year UST rate) + 0.50% (roughly the credit spread of the company) for a total of 1.30%. The relationship between yield and price works like this: when the yield rises, the price falls. So if the 5 year UST rate goes from 0.80% to 1%, all else being equal, the Wal-Mart 5 year bond yield would go from 1.30% to 1.50%, meaning the bond price would fall.
Fixed Rate Mortgages and other Fixed Rate Loans
The rates you get for a US Dollar denominated mortgage and other loans depend on the level of the benchmark UST at the time of loan issuance. Like a corporate fixed income security, the length of the loan determines the benchmark UST rate. The higher the UST rates, the more expensive your mortgage / loan will be.
Equities
The relationship between USTs and equities is quite complex, and there are a lot of factors that determine the strength of the relationship. At the risk of over-generalization, the general relationship between UST rates and equities is the following: As UST rates rise, equities fall. Why? Two main reasons:
The majority of corporations use the debt markets as a tool to run their businesses. As I mentioned in the section above, when UST rates rise, loans get more expensive. Expensive borrowing increases interest expense, reducing the bottom line for the company, making it less profitable.
One of the most common ways to value a company is The Discounted Cash Flow Model. One of the inputs of the model is the discount rate. The higher the UST rate, the higher the discount rate. The higher the discount rate, the lower the present value of the company according to the model.
Understanding how treasuries are priced, what the treasury yield curve is, and the factors that impact treasury yields go beyond the scope of this post. However given how important treasury rates are to other asset classes, I find it important to attempt to understand these complex relationships. I hope that you find this primer to be a decent start in understanding this market and how it impacts other asset classes.
This is not investment advice. For informational purposes only. At the time of publication, I invested in strategies involving USTs, corporate bonds, and equities.