Over the last few years, there have been quite a few hot topics to hit the markets.
In early 2021 it was short-selling. In late 2021, we got inflation and rising interest rates. And as we head into the middle portion of 2022, we’re getting probably the most complex topic of all, and that is the yield curve.
You are undoubtedly going to hear about the yield curve a lot moving forward, as a pretty significant event has just taken place. This would be the US Treasury 2-year yield rising above the US Treasury 10-year yield. In the finance world, this is an event called yield curve inversion.
Why is it important? Historically, an event like this has triggered a recession the majority of the time (more on this later). However, we’ll explain why it’s not as cut and dry as many investors are thinking, and why panicking may not be a good idea.
Of note, the topic can be pretty dry and technical. But we’re going to try to educate our members on what all this means without confusing you or putting you to sleep.
But first, let’s get into the final Premium featured stock here to report earnings, and a company that posted a very respectable quarter, and that is Well Health. After that, we’ll dive into the yield curve and the release of our first module in our NFT course (which as a Premium subscriber, you have access to free.)
WELL Health Technologies
The last of our Bull List stocks to report earnings was Well Health Technologies (WELL) and it did so on the last day of March. The company delivered another strong quarter as it beat on both the top and bottom lines. Of note, it marks the 8th consecutive quarter in which it topped revenue expectations.
WELL also achieved a notable event, and that is profitability. Fiscal 2021 represents the first profitable year in company history. In the company’s outlook, it also guided to profitability in Fiscal 2022 and revenue in excess of $500M. That means WELL is on pace for yet another year of 60% or greater top-line growth.
There really wasn’t anything to dislike about the quarter. The company is now trading at about half the valuations it was this past fall and we believe it provides an attractive entry point as it is trading at only 2 times forward sales. In the short term, it’ll still need some momentum to push it forward but the long-term thesis remains intact – a leading healthcare company.
We’re putting the final touches on our Well Health report, and it should be up to date by mid-week.
Now, let’s move on to the main topic of this week’s newsletter, the yield curve.
What is the yield curve?
In order to understand what the yield curve is, we first need to understand what a bond is, how prices fluctuate, and how coupon rate differs from yield.
A bond is the most common form of fixed income. When originally issued, they will have a par value, a maturity date, and a coupon rate. The par value is what the issuer of the bond promises to pay you back upon maturity, and the coupon rate is the payment it promises to pay you every year along the way.
So, let’s use a publicly-traded company for example. Let’s say Telus is offering a $1000 bond, maturing in 5 years with a 3.5% coupon. In the simplest terms possible, you are lending Telus $1000, and in return Telus will pay you $35 a year, every year for 5 years.
When the bond matures, you’ll get your $1000 back. Typically bonds will issue coupon payments semi-annually, meaning you’ll receive $17.50 for owning this bond every 6 months.
But, the main thing that trips investors up is the difference between a bond’s yield and a bond’s coupon
Much like stocks, bonds trade on a secondary market. If you buy a 5-year bond, you aren’t forced to hold it for 5 years. So, even though the coupon payment is 3.5% on that same Telus bond above, you could be yielding more or less.
Let’s say you buy the 3.5% bond from Telus right now, and interest rates rise 1.25% over the next year as the Bank of Canada predicts. Now you can buy a new 5-year bond from Telus for 4.75%.
Who would buy your 3.5% coupon bond when you can just go get another one for 4.75%? Nobody really, which is why the yield of the bond has to adjust. And, the market will do this by adjusting the price it’s willing to pay for the bond.
Regardless of how rates rise/fall over the next while, you are guaranteed (for the most part) one thing with that Telus bond, and that is it will pay you $35 annually over the next 5 years. So in order for your bond to be as attractive as the new one, it will need to fall in price.
Without getting into the complexities of the bond market and bond pricing (remember, this is supposed to be simple, right?) just know that as rates rise, older bonds become less attractive relative to new ones.
In this situation, if you wanted to sell your bond, you’d likely have to take a capital loss for someone to buy it. They, in turn, would realize a capital gain upon maturity when they purchase it.
Remember, the par value of a bond is paid out on maturity. So, if you sold that $1000 Telus bond above to someone else for $900, it would yield 3.9% ($900 payment for a $35 annual coupon) but it would also net an 11% gain upon maturity (you invested $900, and you will get $1000 when the bond matures). The bond also has a shorter date to maturity than the new one.
So, your bond has now become a little more attractive. Keep in mind, the dollar values represented in these examples are rounded numbers for simplicities sake. By no means do they represent the actual pricing action you’d see in these scenarios.
The opposite is also true. If rates were to decrease, older bonds become more attractive and thus command a higher price.
If rates go down and a new Telus bond has a coupon of 2.25%, your 3.5% bond you purchased above becomes much more attractive. So, someone might pay you $1100 for that bond. They’d yield 3.18% ($35 in annual coupon payments on $1100 invested), which is more they could get on a new bond. But, they’d have a capital loss on maturity, as they’d only be paid out $1000.
So, what does any of this have to do with the yield curve?
As we’ve shown above, bonds have an inverse (opposite) relationship to interest rates. When rates rise, bond prices fall, and vice versa.
So it makes sense that the longer the date to maturity for your bond, the higher the coupon payment will be.
On a 5 year bond, you have your money tied up for 5 years (assuming you don’t sell, of course). With a 30-year bond, your money is tied up for 3 decades. So, you’ll naturally be paid less of a coupon on the 5-year bond as there is less risk with the bond itself.
So if we want to plot this on a graph, with the x-axis (horizontal) being the length to maturity and the y-axis (vertical) being the yield, we should get a gradually trending upwards line, as you’ll see in the chart below (make sure to enable images).
However, this is far from guaranteed. Bonds are still traded by humans, who can realize that situations can be far from ideal, and can also invest based on emotions.
And when we get a situation where the yield curve has inverted, it is something investors certainly need to be paying attention to.
What exactly does an inverted yield curve mean?
When we think of the bond tutorial we just went over above, it seems very odd that someone would be willing to buy a 10-year bond and yield less than a 2-year bond, right?
Well, as mentioned at the start of this piece, this is happening with US Treasury bonds. Why?
As mentioned, yield goes up when prices fall. This is because the coupon of a bond stays the same. Whether it’s worth $1000 or $700, the Telus bond in the initial example we used will pay you $35 annually. However, the yield changes. The person who pays $700 for that bond is going to yield more (5%) than the person who pays $1000 (3.5%).
Bonds operate much like the stock market. As demand rises, prices rise. And as demand falls, prices fall. In a situation where the yield curve inverts, instead of a gradually increasing line, we have a gradually falling line (see the chart below).
This chart is definitely an exaggeration, as the yield curve will rarely invert this much. But, it’s simply highlighted here to give you an idea of the concept.
So why is this happening? It’s because bond investors are buying up long-term bonds (which drives yield down) and are selling off or avoiding short-term bonds (which drives yield up).
Why is this such a significant event?
The world right now is very globalized, and at the center of it is the US economy. So, when the yield curve inverts on government bonds, people tend to pay attention.
For the most part, bond investors are scooping up longer-term bonds as a risk reduction strategy. US treasuries are often thought of as one of the safest investments. So, if investors fear the economy will worsen, they’ll avoid short-term treasuries and buy long-term, which causes the inverted yield curve.
Historically, this type of yield curve inversion has led to a recession 78.5% of the time it has occurred since the early 1900s.
So, what should investors do?
Realistically, nothing. There is a very wide range in terms of delays when it comes to the yield curve inverting and a recession. It could happen as quickly as 6 months, or as long as 3 and a half years. Or, it could simply not happen at all.
There are also a wide variety of yield curves available, comparing a multitude of bonds, and not all have inverted. So stock market bears tend to cherry-pick what negative sentiment they want to highlight.
Economic cycles are a part of investing, and if we attempt to get tricky and sell based on events like this, there are two potential results. We’re either wrong, or we get lucky.
Let investors who buy and sell based on emotion do the guessing. Meanwhile, stick to buying strong companies and holding them for the long term, and you’ll do just fine.
As always, this is a fairly complex subject, but it is one that investors need to know as it is certainly a notable event. So, if you have any questions on the subject head to our Q&A or drop a question on the Discord.
NFT Module 1
We are excited to be launching the first module of our “How to NFT” course. There is simply nothing else like it out there, and we encourage all of you to follow along as we release the other parts in the coming months.
Module 1 covers the basics by explaining what an NFT is and helps investors by categorizing the different types of NFTs. We used the same Sector/Industry classification approach that everyone is familiar with inside the stock markets. While the types may be different, it helps investors better identify the various types of NFTs.
The module has a video, written content, and a quiz to test your knowledge. Our aim is to release a module every week (or two weeks) in the lead-up to our Stocktrades Genesis Pass NFT launch. To date, we have nearly 200 Premium members that have expressed their interest in participating in the project and have claimed their presale spot.
Remember, the NFT is free to all Premium members with active subscriptions (~$250 value) and the course will help walk you through all the necessary steps to get set up. If you’re unsure, at the very least we suggest you follow along with the course to learn about NFTs, as we believe it is important for everyone to have a basic understanding of this space and the potential it offers.
The course will also be available by logging in, selecting “Other Premium Content” in the menu, and Our NFT Course.
Click here to get started with Module 1
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