What it means
The government borrows by selling bills, notes and bonds of different lengths, and each has a yield. When prices rise, yields fall, and when prices fall, yields rise, because the fixed payments are worth more or less compared with the price paid.
The simplest measure is the current yield, which divides the yearly interest by the current price. Yield to maturity is more complete because it also counts the gain or loss between the price paid and the face value received at the end.
Plotting yields against maturity gives the yield curve. A normal curve slopes upward because investors want more return to lend for longer, while an inverted curve, where short-term yields exceed long-term ones, has often been read as a warning about slower growth.
Treasury yields are called the risk-free rate in finance theory, since the government can in principle raise money to repay. Lenders add a margin on top for risk, so a company loan or mortgage typically costs the Treasury yield plus a spread.
Yields reflect expectations about inflation, central bank policy, growth and the amount of government debt on offer. A rise in the 10-year yield, for example, can signal expectations of higher inflation or heavier borrowing.
For businesses, the yield matters in three ways: it sets a base for borrowing costs, it is the starting point for discount rates in valuations, and it gives a measure of what cash could earn without taking credit risk. Finance teams track it every day, and many include it in their weekly management reports.
In practice
Real-world examples.
Example
A company treasurer compares the yield on a 6-month Treasury bill with the rate offered on a bank deposit. She chooses the bill because it offers a similar return with lower credit risk.
Example
A mortgage lender prices a 30-year fixed-rate loan at a spread above the 10-year Treasury yield. When the yield rises, the lender raises the quoted mortgage rate. Borrowers who lock a rate early are protected from further rises.
Example
An analyst building a valuation model uses the 10-year Treasury yield as the risk-free rate. She adds an equity risk premium to find the discount rate for a company's cash flows. She updates the figure each quarter so the valuation reflects current markets.
Formula
Calculation
A quick measure is the current yield:
Current yield = Annual coupon payment / Current price x 100
Take an illustrative Treasury note with a $1,000 face value and a 4% coupon, which pays $1,000 x 0.04 = $40 a year. If the note trades at $950, the current yield is $40 / $950 = 0.0421, or about 4.21%. The yield to maturity is higher, because the buyer also gains $50 when the note is repaid at $1,000, and so it must be calculated with a financial calculator or spreadsheet. If the price rose to $1,050, the current yield would fall to $40 / $1,050 = 3.81%.Case study
Seen in the real world.
Stratford Foods is an illustrative, fictional food manufacturer that planned a $12,000,000 expansion. The finance director wanted to know whether the project would still earn more than its cost of capital if interest rates rose.
She based the cost of capital on the 10-year Treasury yield plus a risk premium and tested three scenarios. At a yield of 4%, the project returned an attractive margin over the discount rate, but at 6% it just broke even.
The board agreed to go ahead with the project but fixed the interest rate on most of the loan before signing. In this illustrative case the yield did rise over the next year, and the fixed rate protected the project from the increase. The finance director now includes a yield sensitivity table in every capital proposal she presents.
Watch out
Common mistakes.
- Assuming a higher yield is always better, when it can simply reflect a lower price and higher risk.
- Using the coupon rate as the yield, when the yield depends on the price paid.
- Ignoring maturity, so that a 2-year yield is compared with a 30-year yield as if they were the same thing. Always compare securities with similar lengths.
Questions
People also ask.
Why do yields move opposite to prices?
Because the interest payments are fixed, so a lower price means the same payments are a larger percentage of the amount invested.
What does an inverted yield curve mean?
Short-term yields are higher than long-term ones, which has often been associated with expectations of slower growth or lower rates.
Why do companies care about Treasury yields?
They set the base for borrowing costs, discount rates and the return on cash. A rise in yields raises the hurdle that new projects must clear.
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