Q&A: Why should you care about rising Treasury bond rates?

The following information was released by the University of Virginia:

With energy prices up nearly 15% in the last year, food costs rising about 3% and overall inflation up 3.4%, there seems to be enough to worry about. Now, 10-year U.S. Treasury bond yields have climbed to 4.96%.

It may not seem like rising Treasury yields should perturb your purse, but finance experts say higher rates can mean higher costs for everything from car loans and mortgages to credit card debt.

To learn more about short-term Treasury bills and longer-term bonds, the market and impact on consumers, UVA Today reached out to Rodney Sullivan, the executive director of the Mayo Center for Asset Management at the University of Virginia's Darden School of Business.

Q. Let's start at the beginning: What is the bond market and how do Treasury bonds work?

A. The bond market is where governments, municipalities and companies borrow money from investors. The U.S. Treasury is the largest issuer in the U.S. bond market, and Treasury securities are among the most actively traded and liquid investments in the world. They range in maturity from a few weeks to 30 years or more.

When investors buy a Treasury security at issuance, they lend money to the federal government in exchange for the promise of repayment and periodic interest payments. The Treasury repays the security's face value, or principal, at maturity.

Once issued, these securities can be bought and sold in the bond market, so their prices and yields change over time. The government's borrowing creates the securities that investors then choose to buy.

Q. Who buys Treasury bonds?

A. The buyers include households, mutual funds, pension funds, insurance companies, banks, foreign governments and the Federal Reserve. In other words, the government borrows from a broad group of investors, not from one single source. These investors may buy Treasury bills and bonds for different reasons: income, liquidity, safety, regulatory requirements or diversification. The amount of issuance by the Treasury and the demand from investors determine prices and thus yields.

Q. How does the bond market affect the average person?

A. The bond market influences the cost of borrowing throughout the economy. The Federal Reserve directly targets a very short-term interest rate, the so-called federal funds rate. Longer-term rates are largely determined in financial markets, where investors assess expected inflation, economic growth, fiscal policy and the supply and demand for bonds. The yields across the range of Treasury maturities are called the yield curve.

That matters to households because interest rates on credit cards, auto loans, student loans and mortgages are linked though in different ways to the yield curve. When rates rise, new borrowing generally becomes more expensive.

Existing fixed-rate borrowers may be insulated, while people with variable-rate loans, such as credit cards or variable-rate mortgages, or those seeking a new loan, feel the effect more quickly. Higher rates can also benefit people who hold cash or bonds by increasing the income available on those investments.

Q. Several events are being blamed for volatility in the bond market, including oil prices, the Iran war, inflation and the federal government's record-breaking $40 trillion in debt. How does that happen?

A. These forces affect the bond market through three main channels: inflation, economic growth and the government's financing needs. Higher oil prices can raise inflation, which may lead investors to expect interest rates to remain high for longer. Geopolitical conflict can have a similar effect if it disrupts energy supplies, while also increasing uncertainty and the demand for safer assets such as U.S. Treasuries. The market response is not automatic and can vary as investors weigh the likely size and duration of each shock.

The federal government's large and growing debt is a longer-term concern. More borrowing increases the supply of Treasury securities that investors must absorb, and higher interest rates increase the government's interest costs as existing debt is refinanced. That can place upward pressure on yields, although the effect depends on growth, inflation, investor demand and the credibility of future fiscal policy.

Yields may also be rising because the economy is now stronger than it was during the unusually low-interest-rate period of the COVID-19 pandemic. An imminent bond market crisis is a much stronger conclusion than the evidence supports.

Q. Any idea what the market will do long-term?

A. It is difficult to forecast bond yields precisely, particularly over short horizons. The key variables are the path of inflation, economic growth, Federal Reserve policy and the government's fiscal outlook. If inflation moves sustainably toward the Federal Reserve's 2% objective and fiscal concerns ease, long-term yields could fall. If inflation remains stubborn or investors demand more compensation for fiscal and inflation risk, yields could stay higher or rise further.

For investors, higher yields reduce the market value of their existing bond holdings, but they make newly purchased bonds, including reinvestment of bond payments received, more attractive because they offer more income. Higher yields can also put pressure on stock valuations and contribute to market volatility, but that does not guarantee that money will move from stocks into bonds or lower bond yields.

The best conclusion is that the bond market adapts to the economic and political environment. Incoming data and policy responses will determine how far that adjustment goes.