Introduction: Any investor following the markets, reading the business section of their favorite newspaper, or receiving a weekly newsletter from their respective investment company would have noticed an increased mention of bond yields and/or the yield curve over the past few months. Unless you are a professional investor, most individuals would have asked themselves what on earth is that? Are these factors that important and how are these factors linked to vital economic and market factors such as economic growth, inflation, interest rates, and earnings growth? The short answer is yes, bond yields and the resulting yield curve are very important investment topics that tend to have a big effect on the market. I will attempt to put bond yields and the yield curve in perspective and explain their relative importance by answering some of the more generally asked questions about these topics.

What is a bond yield? In short, a bond yield refers to the return on a bond when held until maturity. Similarly, when one talks about the yield on cash, you refer indirectly to the return on cash. Just like cash, bonds give an investor income in the form of a coupon (like interest). These coupons are fixed and usually paid twice a year. The yield on your bond is the coupon divided by the price you paid for the bond. For example, if you pay R1000 for a bond that pays you an annual coupon of R100 the yield on the bond will be 10% (R100/R1000). Bonds trade in the open market which means the price of a bond can fluctuate resulting in the bond yield increasing or decreasing.

What is a bond price? The confusing part comes in when investment professionals and commentators talk about rising/declining bond yields and declining/increasing bond prices without distinction. That is because they are referring to the same thing. When bond yields go up it means that the price of the bond has decreased and vice versa. Bond prices fluctuate with changing market sentiment and the economic environment. The greatest influence on bond prices are interest rates, which normally tend to change when inflation changes. Bond prices have an inverse relationship with interest rates. In other words, when interest rates go up the value of bonds (In the secondary market) go down and vice versa.

What is the yield curve? The yield curve is created from various data points. The yield curve is the line that forms when plotting the yields of similar-quality bonds with different maturities, from the shortest to the longest maturity. This line can either be flat, slope upwards or downwards as per the examples below.

If short-term bond yields are lower than long-term bond yields the yield curve is upward sloping and called a positive or normal yield curve. If short-term bond yields are higher than long-term yields the line is downward sloping and called negative or inverted. If there is little difference between yields the resulting yield curve is called flat. In a recession, the yield required from long-maturity bonds tends to be low (bond prices are high) since investors expect interest rates to decline from prevailing levels, while yields on short-term maturity bonds are comparatively high as the interest rate cutting cycle takes time to implement. This results in an inverted yield curve. The converse situation occurs in expansions, with longer-dated bonds reflecting higher yields due to an anticipation of rising inflation and higher interest rates in the years ahead. A flat curve indicates that there are no strong views on either growth or inflation. In summary, the slope of the yield curve gives an idea of future interest rate changes and economic activity.

Why is this important? In South Africa, the slope of the yield curve has historically anticipated changes in the economic cycle (by between three and eight months). Earnings growth for companies, and hence the overall market, move in tandem with the economic cycle and you would therefore expect the yield curve to anticipate the earnings growth of the market.

How is it relevant to my portfolio? Over the longer term, the most important driver of share prices and hence returns is earnings growth. Where earnings go prices will eventually follow. The slope of the yields curve provides a good indication of economic turning points, the economic cycle and earnings growth.

Conclusion: Rising bond yields typically signal investors are hopeful for more economic growth in the future but they can also indicate that a potential spike in inflation is just around the corner. Often investors worry that an increase in bond yields and longer-term interest rates will have a negative effect on market returns. However, if rates are rising because the economic growth outlook is picking up, higher interest rates should not deflect the stock market. Unless there is a sustained inflation surge, rising bond yields may only have a minor impact on stocks.