Bond Market: Convexity & Carry Explained

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Bond Market’s Hidden Advantages: What Investors Need to Know Now

While the stock market often grabs headlines, the bond market offers a deeper look into economic health and government strategy. Unlike stocks, which can be swayed by short-term excitement, bonds mirror investor confidence, inflation expectations, and how well a country manages its finances. Recent movements in the bond market have caused concern, signaling potential shifts that could affect everyone.

Decoding Bond Yields: A Fair Value Outlook

Looking at the bigger picture, there’s a growing risk of higher government yields. Yields on bonds in a country’s currency, like the U.S. Dollar, depend on three main factors: economic growth trends (around 1.5% to 2%), inflation expectations (currently about 2% to 2.5%), and the term premium (the extra return investors want for holding longer-term bonds).

These factors determine the “fair value” yield for a 10-year U.S.Treasury note. Analysts estimate this fair value to be between 4.6% and 6.8%.With today’s 10-year Treasury yield around 4.50%, there’s a possibility that yields could rise further.

Convexity and Carry: The Bondholder’s Safety nets

Bonds aren’t simply a losing bet when yields increase. Currently, two technical aspects, known as convexity and carry, are subtly giving bondholders an advantage, a welcome change from the difficulties of 2022.

Understanding Convexity

Convexity refers to how a bond’s price sensitivity (duration) changes with interest rates. Positive convexity means that if yields decrease,bond prices will likely increase more than they would decrease if yields increased by the same amount. For example, in today’s market, a 10-year yield at 4.50% might gain 11% if yields drop to 3.50%,yet only lose 3% if yields climb to 5.50%. This asymmetrical payoff makes bonds a compelling hedge against economic slowdowns or potential rate cuts.

The Role of Carry

Carry represents the income from coupon payments – for instance, 4.5% annually on a 10-year Treasury note. It acts as a safety net: even if prices fall as of rising yields, the coupon will offset losses over time. Over a year, carry can reduce the impact of small to moderate yield increases.

Pro Tip: Consider diversifying your fixed-income portfolio to include bonds with varying maturities to balance risk and return in a changing interest rate surroundings.

Why This Isn’t 2022 All over Again

In 2022, bondholders incorrectly predicted falling yields during high inflation, resulting in significant losses as the Federal Reserve aggressively raised rates. Today, with higher yields and the Fed’s next move uncertain, convexity and carry provide crucial support. Repeating the strategies of 2022 would mean ignoring the current market’s changed dynamics.

A recession caused by slowing demand, combined with low inflation, could lead to a drop in yields if the Federal Reserve cuts rates to boost the economy. This potential for significant gains explains why bonds remain attractive,especially while recession risks persist.

The Risk-Off Puzzle: Why Aren’t Yields Falling?

The market’s recent behavior has created confusion. Historically, a “risk-off” environment-where investors sell stocks and buy safer assets like Treasuries-typically lowers yields. However, despite the recent stock market decline, U.S. 10-year yields have been rising. This suggests a negative view of government debt, potentially due to tariffs, concerns about government spending, or lingering inflation fears from 2021-2022. Investors may worry that massive deficits and ongoing price increases outweigh the traditional safety of bonds.

The 10-year swap spread-the difference between U.S. Treasury yields and swap rates-provides a hint. This spread reflects credit and liquidity risks related to Treasuries. It jumped to 60 basis points recently, then decreased to 50 basis points after the administration temporarily paused tariffs (except on China). However, it has since climbed back to 55 basis points, indicating continued unease. A widening spread implies that even during risk-off periods, Treasuries aren’t seen as the safe haven they once were.

Eyes on New 2025 Highs

Current market sentiment points toward the U.S. 10-year yield surpassing the January 2025 peak of 4.80%. Several factors contribute to this, including federal Reserve policy: a cautious approach, wary of renewed inflation, limits expectations of rate cuts and keeps yields high. Supply pressure also plays a role: the Treasury’s heavy borrowing-estimated at $2 trillion annually-floods the market, pushing yields up. Additionally, global demand is shifting as foreign buyers, who were once strong supporters of Treasuries, diversify their reserves, reducing their demand.

If the yield rises above 4.80%, borrowing costs will increase, testing the limits of policymakers’ reliance on affordable debt.While the long-term outlook for the bond market suggests higher yields-potentially creating challenges for policymakers-the current structure offers bondholders some protection, with convexity and carry helping to manage potential losses.

Did You Know? The U.S. Treasury is the largest single issuer of debt in the world,influencing global interest rates and financial stability.

Bond Market Outlook: Key Factors

the bond market’s future hinges on several key factors that investors should monitor closely. These elements will likely shape returns in the coming months.

Factor	Description	Potential Impact
Federal Reserve Policy	The Federal Reserve’s decisions on interest rates and quantitative easing.	hawkish policies could increase yields; dovish policies could decrease them.
inflation Expectations	Market forecasts for future inflation rates.	Higher inflation expectations typically lead to higher bond yields.
Treasury Supply	The amount of new debt issued by the U.S. Treasury.	Increased supply can put upward pressure on yields.
Global Demand	Demand for U.S. Treasuries from foreign investors.	Decreased demand can lead to higher yields.
Economic Growth	The pace of economic expansion or contraction.	Slower growth may lead to lower yields as investors seek safety.

Evergreen Insights on Bond Investing

Investing in bonds requires a strategic approach that considers both current market conditions and long-term financial goals. Here are some evergreen insights to guide your bond market investments:

• Diversify Your Bond Portfolio: Don’t put all your eggs in one basket. diversify across different types of bonds (government,corporate,municipal),maturities,and credit ratings to reduce risk.
• Understand Interest Rate Risk: Be aware that bond prices move inversely to interest rates.When interest rates rise, bond prices fall, and vice versa.
• Consider Your Time Horizon: Match the maturity of your bonds to your investment timeline.If you need the money in a few years, shorter-term bonds may be more suitable.
• Assess Credit Risk: Evaluate the creditworthiness of bond issuers. Higher-rated bonds are generally safer but offer lower yields, while lower-rated bonds offer higher yields but carry more risk.
• Rebalance Regularly: Periodically review and rebalance your bond portfolio to maintain your desired asset allocation and risk level.

Frequently Asked Questions About the Bond Market