Milton Reese: U.S. Bonds Rank No. 1 Globally
Alright, let’s start with a guess: Which country has the largest fixed income market in the world?
The answer is pretty straightforward—it’s the United States. As of 2023, the U.S. fixed-income market has a total value exceeding $51 trillion, making up 41% of the global market. No doubt, it’s the biggest out there.
The U.S. bond market is known for being the "most liquid and efficient" worldwide. U.S. bonds not only reflect the current logic of global financial markets but also have a transmission effect on the pricing of other major asset classes. This is why analyzing U.S. bonds is important.
From the perspective of product classification, U.S. bonds include government bonds (i.e., Treasuries), corporate bonds, municipal bonds, and mortgage-backed securities. Among these, Treasuries are the largest category in the U.S. bond market. Treasuries are part of the U.S. sovereign debt and are typically considered almost risk-free because they are backed by the U.S. government. Therefore, U.S. Treasury rates are regarded as risk-free rates and are favored by large government and individual investors worldwide.
U.S. Treasuries are a way for the federal government to finance its fiscal deficit. The repayment period, or maturity, ranges from 1 month to 30 years.
I categorize Treasuries based on their maturity into three major types: short-term Treasury bills (maturing within 1 year), medium-term Treasury notes (maturing in 2 to 10 years), and long-term Treasury bonds (maturing in more than 10 years).
The yield on U.S. Treasuries is the effective interest rate paid by the government on its debt, which, from my perspective, is the annual return expected by investors holding these bonds.
Treasury yields reflect not only the cost of financing for the U.S. federal government but also investors' expectations for economic prospects. Among Treasuries with different maturities, short-term Treasury yields are the most sensitive to monetary policy and tend to be more volatile than long-term Treasury yields. Medium- and long-term Treasury yields include a "term premium" based on short-term Treasury yields, reflecting future expectations of U.S. fundamentals. Therefore, changes in short-term Treasury yields will inevitably affect medium- and long-term Treasuries.
Now, a common question is: Does a rise in Treasury yields increase the U.S. debt burden?
To answer first, not necessarily. The issue of U.S. government debt is not the main contradiction in Treasury pricing because the Treasury's borrowing cost is determined at the moment of issuance, and subsequent changes in Treasury yields do not affect the cost of existing debt. Rising Treasury yields mean falling prices, which will be discussed later. Therefore, rising Treasury yields actually help reduce the nominal value of the debt.
The price and yield of bonds determine their value in the secondary market, and this relationship can be seen from the formula:
Current yield = annual coupon payment / current market price
Obviously, price and yield move in opposite directions. When bond prices go up, yields go down, and vice versa.
Grasping this relationship is crucial for successful bond investing. Rising yields indicate lower demand for Treasuries, possibly because investors prefer higher-risk, higher-return investments at that time; falling yields indicate the opposite.