This is a guest post by Sam, author of Financial Samurai, “How to Engineer Your Layoff,” and founder of the Yakezie Network.
Finance and investing don't have to be complicated. Consistently buying low and selling high can make you rich beyond your wildest dreams. Of course, if investing were so easy, we would all be kicking back and letting our money work for us instead of slaving away at the office every day.
When I started working on Wall Street in 1999, it felt like I was drinking from a fire hydrant because I was inundated with financial metrics. As a good institutional equities salesman, I should know the latest GDP forecasts to get a grasp of the overall macro momentum of the country. I'd then need to be able to speak eloquently about inflation expectations to differentiate between real and nominal growth. Finally, I'd have to drill down to a stock's specific sales, operating profit, net profit, and margin assumptions to figure out whether the company was a buy or sell.
After a couple years of what felt like groping in the dark, pretending like I knew more than I really did, I finally found one metric that was more powerful than the rest. By studying this one metric thoroughly, I was able to confidently talk to investment professionals 20 years my senior in a reasonably intelligent manner. I dare say that this one simple metric encapsulates almost everything there is to know about finance.
I'm not going to promise you after reading this series of articles that you will suddenly become an investing guru. What I will say is that hopefully this article will help you see the financial world with anti-glare, polarized lenses. By seeing things more clearly, you can drastically improve your chances of making profitable investments. With more profitable investments, it's only a matter of time before you achieve your financial goals.
Introducing the 10-year Treasury yield
The 10-year Treasury yield is the yield on a U.S. government Treasury bond. The U.S. government regularly issues Treasury bonds to raise money to help fund the national budget. In case you don't know, the U.S. budget has been in a massive deficit of $1 trillion-plus for the past five years. Only in 2013 are we actually forecasted to see a deficit below $1 trillion, thanks to economic growth, increased tax receipts and slightly lower spending.
As of August 2013, the largest holders of U.S. Treasuries by country are China, Japan, Brazil, Taiwan, and Switzerland, according to treasury.gov. Foreigners buy U.S. debt as a way to diversify their own investments as well as to recycle the proceeds they receive from their exports to America, such as, Chinese-made toys sold in the U.S.
The 10-year Treasury yield is also known as the risk-free rate. Why? The reason is because the U.S. government is considered the most solvent, credit-worthy country in the world, despite running a massive budget deficit, and in spite of the recent debacle on Capitol Hill. Just ask yourself whether you'd feel better buying a U.S. government bond or a North Korean government bond. Surely you would choose the former.
Part of the reason why U.S. Treasuries are so safe is because the U.S. dollar is a world currency which is also artificially manipulated by America's ability to print money. There's virtually no chance the U.S. will default on its debt because, when things get tough, the Treasury department can always print more money to pay off debt. When things get really tough around the world, foreign money buys even more U.S. debt. Without the printing press, faith in the U.S.D and U.S. assets would wane, leading to a massive depreciation of U.S. assets.
Now that we know the sanctity of U.S. Treasuries, we can dissect what goes into the latest 10-year Treasury yield which changes every single trading day.
What the Treasury yield tells us
Some of you might be skeptical about the power of one single metric, but please give me a chance to explain what the latest 10-year U.S. Treasury yield means for your investments and for your personal finances. Let's run through assumptions based on a 10-year yield at 2.7 percent.
Opportunity cost: Given you can make a 2.7 percent annual return doing nothing with no risk, your investments had better provide a return greater than the risk-free rate of return due to risk. This 2.7 percent return is close to an all-time low — 1.6 percent was the low reached in the fall of 2012. In other words, your hurdle rate is also close to an all-time low, making the alternative — equities — much more attractive than if the risk-free rate was 10 percent.
When the risk-free rate fell below 2 percent, smart money was flooding into equities because the S&P 500 dividend yield alone was over 2 percent. With cheap valuations based on historical levels and a 2 percent market dividend yield, the risk/reward was to the upside for buying stocks and selling bonds at all-time highs. One should generally always look to buy stocks when the stock market dividend yield is greater than the 10-year bond yield. The same thing goes for buying CDs when their yields are higher than Treasury yields as well.
Inflation expectations. Everything is Yin Yang when it comes to finance. Interest rates rise due to the expectation of higher inflation and fall when there is an expectation of low inflation. With a 2.7 percent Treasury yield, we know that U.S. inflation is therefore no greater than 2.7 percent because nobody will buy a bond with a 10-year duration if it provides a negative real rate of return.
To illustrate, let's say the Consumer Price Index (CPI) is currently at 4 percent. If you buy a 2.7 percent yielding bond, your real return would be negative 1.3 percent (2.7 percent minus 4 percent) a year so long as inflation is at 4 percent! The only reason you would buy a 2.7 percent-yielding bond when inflation is at 4 percent is if you believe inflation will drop below 2.7 percent quickly or may even go negative as in a period of deflation. Deflation is a very difficult economic situation where the expectation of a decline in prices leads to further declines because nobody is willing to buy anything when they can wait for cheaper prices in the near future. Deflation is often feared most by the Federal Reserve, followed by hyper-inflation.
If you understand the 10-year Treasury yield, you have an idea, more or less, of where inflation expectations are at any time in history. In 1990, the 10-year Treasury yield was around 9 percent. That means inflation was running likely between 6 to 9 percent a year. Pretty neat, right?
It's important to note that there is no inherent bad or good Treasury yield number. If Treasury yields are high, then asset inflation is high, which is good for asset holders and bad for price takers. When Treasury yields are low, asset-light investors are hurting less and should use this time to accumulate more assets.
* Risk appetite. If investors are accumulating bonds with yields below 2 percent, that means there is a “risk off” mentality. Investors are willing to accept under 2 percent annual returns because something bad must be going on in the world to run away from equities, which have historically returned 8 percent. Look at how Treasury yields dropped during the dotcom bubble, Gulf War, SARS epidemic, and housing crisis. Investors were basically screaming “save me!” as stocks and real estate declined.
If investors aren't willing to buy US Treasuries yielding much higher levels such as 8 percent, it must mean that there's a “risk on” mentality where there are potentially much more lucrative investments from which to choose. There may also be the expectation of much higher inflation and, therefore, higher rates due to perhaps an extremely loose monetary policy and a very tight labor market. Treasury yields can tell the overall market's risk appetite.
* How the world sees the US. As we discussed earlier, foreigners are huge buyers of US Treasuries. The lower the Treasury yield, the more accepting the financial world is of the United States — otherwise foreigners would be selling Treasuries instead. If the United States suddenly threatened to launch nuclear weapons against Canada and Mexico to expand their footprint, Treasuries would sell off in a hurry and yields would spike.
The problem with being a big holder of US Treasuries is that if a country like China ever wants to sell, they may cause a huge dislocation in the Treasury markets. Hence, foreigners are almost stuck into continuously buying our debt even when yields are so low.
There is a lot of angst against US foreign policy, but the important thing to focus on as an investor is watching what institutions do with their money and not what they say.
* Profit opportunities. There is a big world of macro investors out there who move a lot of money. George Soros may be one of the most famous macro investors who broke the Bank Of England by shorting the pound and making a billion dollars in 1992. I don't recommend macro investing until you've got a good grasp on economics and finance, but you can be your own “mini” macro trader with the 10-year Treasury yield.
I'm a big fan of exchange traded funds (ETFs). The easiest 7-10 Year Treasury bond fund is the un-leveraged ETF IEF by iShares. IEF goes up when yields go down (Treasury prices go up). If you want to profit from rising rates (falling Treasuries), then you can buy the inverse bond ETF TBF called the ProShares Short 7-10 Year Treasury.
For those who are confused with the inverse relationship between bonds and yields, here is a simple example:
Bond Yield = Coupon Payment/Bond Price
- Bond price = $100
- Coupon payment = $10
- Bond yield = 10 percent
If the bond price goes down 50 percent to $50, the coupon stays at $10, then the bond yield rises to 20 percent ($10/$50 = 20 percent).
If the bond price goes up by 50 percent to $150, the coupon stays at $10, then the bond yield falls to 6.7 percent ($10/$150 = 6.7 percent).
US Treasury bonds should be a part of every person's portfolio. You can buy bonds to profit, hedge, or reduce volatility in your portfolio. Always check whether you need to “re-balance” once a year.
So there you have it. The 10-year Treasury yield, can give you a good idea of your opportunity cost to invest, where inflation is at any given point, and how you should feel about risk. It can also provide insight into how US foreign policy may affect markets and how to identify profit opportunities. Pretty powerful stuff if you ask me!
Treasury yields and your net worth
Feeling financially emboldened yet? The easiest way to track the 10-year Treasury yield is on Yahoo Finance. Now that you can speak more eloquently about economics and the stock markets, let's drill down to how the 10-year Treasury yield can help you make the proper net worth asset allocation.
I'm a big believer in not only diversifying your stock portfolio but also in optimizing your net worth as it grows in value. Once you build a sizable financial nut that is spitting out a viable passive income stream, your goal is to protect it like Sparta!
Most home buyers take out a mortgage to finance their property purchase, and understanding that the 10-year Treasury yield is closely correlated to mortgage rates is critical information for them. When the 10-year Treasury yield was at 1.6 percent, for example, one could lock in a 30-year, fixed-rate mortgage at 3.5 percent or a 2.5 percent 5/1 ARM. With the 10-year yield now over 2.6 percent, mortgage rates have risen commensurately by roughly 50 basis points to 100 basis points.
When Treasury yields are low, the demand for borrowing money increases. Much of the demand for cheap money goes toward property. As demand increases, so do property prices all else being equal. In a low-interest-rate environment, one should look to lever up and buy real assets which have the potential for appreciation such as property. Nothing is guaranteed (as we all know from the housing crisis), but cheaper mortgages means the opportunity cost of not owning property increases as rents rise.
Treasury Yields have risen violently in 2013 from 1.66 percent to as high as 2.98 percent recently. And while 2.98 percent is still low by historical standards, the pace of increase caught many home buyers and bond holders by surprise. This is why bond funds got smashed during the summer of 2013. Such a quick increase in rates should serve to dampen demand and price increases in real estate until the economy “catches up” to new, higher rates. Remember to always think about increases at the margin.
By keeping track of the latest 10-year Treasury yield, you think much more rationally and much less emotionally during a property-purchase or property-sale situation.
My current property asset allocation: 35 percent of net worth. Goal is to reduce the weighting to 30 percent by selling one of my rental properties due to a rebound in property prices and my desire to simplify life. Real estate is my favorite investment class for building long-term wealth.
With the 10-year yielding 50 basis points (bps) more than the S&P 500 dividend yield and the S&P 500 at record highs, I am no longer 100 percent allocated toward stocks (equities) in my rollover IRA. I've decided to limit my equity exposure to 75 percent equities and 25 percent bonds within my investment portion of my net worth.
One of the saddest situations was when retirees in 2007 to 2009 saw their portfolios get decimated by 30 to 50 percent. I wrote a post in 2012 on GRS entitled, Finding Hope In The Bleakest Of Situations where I, too, lost about 35 percent of my net worth in a matter of months after 10 years of 50-percent-plus savings. Everybody thinks they are stock market geniuses in a bull market. But as Warren Buffett once said, “Only when the tide goes out do you see who's naked.” Don't confuse brains with a bull market!
The historical performance of the S&P 500 is, thankfully, up and to the right. But there are nasty corrections in between. We'll never know for sure when the next bear market cycle will be, which is why we should reduce exposure to stocks the closer we are to retirement.
My current stock/bond asset allocation: 30 percent/10 percent of total net worth. If the 10-year Treasury yield breaks 3 percent, I'll be shifting to a 25 percent/15 percent allocation.
Safe assets include money market accounts and certificates of deposit (CDs) up to $250,000 per individual or $500,000 per married couple thanks to FDIC insurance in case your bank goes under. You can open up multiple CD or money market accounts with different financial institutions if you have more than the $250,000/$500,000 to spread around. It is always important to have a portion of your net worth in safe assets because bad things happen in the markets all the time if you invest long enough.
About 25 percent of my net worth is currently allocated in 7-year CDs yielding a blended 4 percent annual return. This was a fantastic rate when the world was coming to an end in 2008 to 2009, but not so much now that we've been seeing double-digit returns in the stock market for the past several years. A 4 percent CD yield is still much greater than the current 10-year yield of approximately 2.7 percent, but CDs also don't have a chance for principal appreciation.
When your CDs expire, invest in CDs that provide an interest-rate equivalent to at least the 10-year yield or greater due to inflation. The best CD rate I can currently find is a 7-year term at around 2.35 percent. As a result of low CD interest rates, I'm looking at CD-investment alternatives to boost return.
My desired CD allocation over the next three years: 25 percent of net worth going down to 15 percent or less.
Cash is a safe asset that deserves a section of its own. They say “cash is king,” but not so much in a bull market as we are experiencing now. Cash should be viewed mainly for emergency liquidity purposes. Cash provides no return and the amount you have should be dictated by your daily or monthly operational needs. Given CDs are FDIC insured, holding too much cash is a sub-optimal strategy since you could be earning at least 2.35 percent risk-free.
To determine how much cash is enough, calculate a realistic emergency fund amount based on cash withdrawal rates over budget for the past three years. Of course, if you are expecting a large upcoming expense such as a wedding, graduate school tuition, a relocation, or an investment, allocate more cash accordingly.
Bottom line: The lower the interest rate on the 10-year Treasury, the lower the return on less risky asset classes. Reallocate your net worth toward higher-yielding asset classes.
Treasury yields and loans
So far we've been focused on using cheap money to invest in other assets that can potentially provide greater returns. But what if you are not ready for investing and are still digging yourself out of a debt hole?
In this current low-interest-rate environment, now is absolutely the right time to shop around for lower rates. The worst kind of loan is a credit-card loan because the average interest rate on credit cards is around 15 percent. Despite a drop in Treasury yields over the past 10 years, credit card interest rates have remained fairly stable. As a result, profit margins have expanded if we assume default rates stayed steady. If you've been responsible in paying your credit card bills on time, I urge you to call your credit card company now and negotiate a lower rate today.
Mortgage rates and car loan interest rates are much more closely tied to interest rates partly due to fierce competition. The car industry went through near death and needed to entice consumers to buy during the 2008-to-2011 period. As a result, zero percent car loans for three years were common just to move the product. I'm a big advocate of never taking out a car loan. I truly believe a car is the Number 1 personal finance killer for people today. To compound buying a depreciating asset with a loan that charges interest is just wrong.
One of the best rules of thumb for buying a car is to spend no more than 1/10th your gross income on the purchase price of a car. The 1/10th rule helps motivate you to save and earn more if you want a certain type of car. The rule also keeps people from overly destroying their finances since a car is guaranteed to depreciate and takes money away from investing.
Banks realized they were too strict in their mortgage-lending practices in 2010 and 2011, and they are now more aggressive in mobilizing their overcapitalized balance sheets. Unfortunately, industry reports are showing that the refinance boom is temporarily over with a spike in interest rates in 2013 due to perceived tapering by the Federal Reserve. With the nomination of former UC Berkeley professor Janet Yellen as the next Fed Chair, we should see a continued accommodative Federal Reserve based on her record. Watch the 10-year yield closely and consider calling your mortgage broker to check the rates if the yield goes below 2.5 percent again.
Unless you are taking out a loan to buy an asset that has a chance of appreciating, please keep borrowing to a minimum despite low rates.
If you keep track of the 10-year Treasury yield and master its underlying meanings, you should be able to get a much stronger handle on your finances. Use the latest 10-year Treasury yield as a benchmark for every single investment you make to help take emotion out of the equation. The goal is to one day build a large enough net worth so that your money is generating perpetual passive income based on your personal risk tolerances.
What is your asset-allocation strategy and how did you decide on it? If you have any questions on the 10-year government bond yield please feel free to ask.
Author: Financial Samurai
Sam spent 13 years working on Wall Street in the equities department at a couple bulge bracket firms before deciding to focus full time on Financial Samurai, a personal finance site that helps you slice through money's mysteries. Sam received his MBA from UC Berkeley's Haas School of Business and his Bachelor of Arts in economics from The College of William & Mary. He is a registered representative (Series 7 and Series 63).
Sam is based in San Francisco, California, and enjoys playing league tennis, poker, and anything that deals with the great outdoors. Sam's goal is to live a location-independent lifestyle by generating enough passive income to take care of a family of four.