Understanding Treasury Bond Yields and Returns

The recent yield on the monthly Treasury bond stands at 1.59%. This rate can often be confusing, especially when it comes to its implications on returns over time. Let's explore this in detail, factoring in the impact of inflation and the nuances of bond yields.

Common Misconceptions and Realities

It is a common misconception to believe that if one continuously buys Treasury bonds, allows them to mature, and reinvests, they would see a compounded return like 1.0159^12 20.84%. However, this calculation ignores several important factors, including inflation and the way bond yields are expressed.

The Impact of Inflation

In an era where inflation has significantly eroded the purchasing power of money, simply growing your investment by a fixed percentage does not account for these losses. For instance, the US dollar experienced dramatic erosion since 1920, dropping to nearly zero in buying power by the end of 2019. A dollar from 1920 would be worth about $80 in today's dollars. This underscores the importance of considering inflation when evaluating long-term investment returns.

Correcting the Monthly Yield Calculation

To accurately gauge the monthly return, one must adjust the annual figure. Since the yield is an annualized measure, you would need to convert it to a monthly basis. The formula involves dividing the annual yield by 12:

1.59 / 12 0.1325%

For a more precise calculation, using a spreadsheet can be beneficial. With 0.1325% monthly, a $1,000 investment would be worth $1,001.59 after one year.

The Derivation of Treasury Yield

Treasury bond yields are not based on monthly returns, but rather on annual returns. The annual yield, denoted as the Annual Percentage Rate (APR), is periodically expressed as a monthly figure for convenience. However, it is crucial to recognize that a US Treasury has never paid a monthly yield like 1.59% since the 1970s, due to the rampant inflation of that era. This confusion often arises because other investment vehicles can offer much higher returns, making Treasury bonds seem mildly attractive.

Market Pricing and Capital Gain

Another critical factor to consider is that the yield reflects the market price, not the face value of the bond. The market price of bonds fluctuates, which means that yields can go up or down without any change in the coupon rate. When people say the yield on 10-year bonds is falling, it actually indicates an increase in the capital value of the bonds due to fixed interest rates. This means that if you own bonds, their value increases, allowing for a higher resale price. On the other hand, if you are considering investing, you need to understand that the bond's price has already increased, offering less attractive entry points.

Key Takeaways

1. Treasury yields are annualized measures, not monthly.

2. Inflation significantly impacts the real value of investments over time.

3. Market pricing of bonds plays a crucial role in determining yields.

4. Understanding the nuances of bond yields is vital for accurate financial planning.