Mining foreman R. Thornburg shows a small cage with a canary to test carbon monoxide gas in 1928.
The canaries served both as pets and as harbingers of poisonous gases for British miners starting as early as 1911. What made the birds preferred and more effective than mice or other small animals is their physical anatomy. To fly in high altitudes, canaries have extra oxygen sacs in their lungs to pull more than twice the amount of oxygen (and toxins) compared to other animals their size. Fortunately, by the 1980s, these birds started being replaced by electronic detectors, thus ending the era of canaries in coal mines.
While the birds are gone, the phrase has stuck around. On Wall Street, the brightest minds in moving and making money pay careful attention to canaries announcing a potential slowdown in the economy, followed by a correction in the markets. Last year, I wrote about the repo markets as one of these birds. Since then, Covid-19 heavily impacted the business landscape with mandatory shutdowns worldwide and layoffs impacting thousands of employees. Yet, six months later, the stock market has shrugged off the virus like a bad hangover.
Are we in a bubble? As an emerging investor, how can we know that the smart money on Wall Street won’t just pull the rug out underneath us tomorrow? Current models predict a 19% chance of a prolonged recession into September of next year. Let’s dive in to understand the model and explore an investing strategy proposed by Jeff Bezos used exclusively on Wall Street.
Bonds, Bills, and Notes
Bonds, bills, and notes all describe debt that’s borrowed and backed by the U.S. government. Bonds are long-term debt issued by the government over periods of 20 years or 30 years. Notes are medium-term debt issued over 2, 3, 5, 7, and 10 years. Both bonds and notes pay interest to the lender at the rate specified by the bond's coupon every 6 months. Bills, on the other hand, are short-term debt and range from a few days to a year. Instead of paying interest, these notes are sold at a discount, e.g., a 1-year note might be sold to us for $98 with the promise that the government will pay us $100 in a year from now.
The US government's debts are important because they represent a store of value backed by currently the world’s strongest and most mature economy and are bought in large quantities by investors at home and abroad. Akin to safe-haven commodities like gold, bond prices tend to have an inverse relationship with stock prices. The time value of money explains this and the requirement for investors to constantly earn a return—if stocks are no longer a good asset for returns, investors will purchase bonds that pay interest instead of holding cash.
Bond price action and yield
Bonds are usually written and sold in increments of $1,000, the face value, and typically ranged from $1,000 to $10,000—to make bonds more accessible, bonds with a face value of $100 can now be purchased. At the end of the loan period, let’s say 20 years, the government will pay us the face value, which is separate from the interest payments collected over the time period. However, comparing price movements of $100 face value bonds with $10,000 face value bonds can be like looking at the scratches in the dirt next to the grand canyon. Instead, most investors plot the yield of the bonds and notes.
The yield is the expected yearly return of a bond factoring in the price fluctuations and the stated coupons. It’s the same idea as a dividend yield and can be calculated by taking the coupon divided by the bond's current price. Here’s an example:
The US Department of the Treasury issued a 30-year bond with a face value of $1000. The bond promises to pay a 6% annual coupon or $60 of interest per year and is currently selling for $1010 because some investors are nervous about a possible recession and willing to pay for a higher price for the bond. The yield is 5.94%, or $60/$1010.
We’ll notice that the yield is lower than the coupon rate because we’re paying more for the bond and earning a lower return. This sets up our second inverse relationship: yield of bonds vs. price of bonds. As you might be realizing, if both yield and stock prices move in the opposite direction with bond price, then they must move in the same direction—yield goes up if stock prices go up.
The 10-year canary
The 10-year US treasury note, specifically the note's yield, is the most widely tracked across Wall Street. The yield influences mortgage rates, auto loans, corporate loans, student loans, and even annual APR on credit cards. The Federal Reserve also tracks the 10-year note closely and decides future monetary policy based on the yield. Wall Steet will go one step further and take the yield of a 10-year note and compare it to the yield of a much shorter bill. The difference between the two is called the yield curve.
The yield curve describes the payoff of short-term bills to long-term bonds. A normal yield curve looks like this:
Normal yield curve
In the graph above, longer-term bonds pay us a larger yield since our money is locked up for longer.
An odd phenomenon happens where the yield curve flattens out and then inverts right before a recession. The yield on short-term bonds becomes higher than long-term bonds.
Inverted yield curve
Let’s unpack what’s happening when the curve inverts. Bonds and notes are now paying lower yields than bills. If we think about the inverse relationship of yield to price, we know that bonds and notes are rising rapidly while the bills' price decreases. Simply put, investors are anxious about the near future and are choosing to park their money much further down the road when the economy is likely to be on the path to recovery. Interestingly, the yield curve's inversion correctly predicted every recession in the last 50 years except for one false alarm in the late '90s.
2-year treasury note yield subtracted from 10-year treasury note yield.
The grey areas on the chart above indicate each recession we’ve had. The line graph is the spread or difference between the 10-year note compared to the 2-year note. When the yield curve inverts, the 10-year note yield will be lower than the 2-year note yield, and thus the line dips below zero. If we double-click into the spread for this year, we can see that, in recent months, the 10-year yield is starting to make up lost ground over the 2-year.
The current spread is 0.70% or 70 basis points.
When the spread widens, the yield curve starts to steepen, marking a sell-off of longer-term bonds and notes. In this case, investors are more optimistic about the near future and are looking to reinvest their money into stocks and shorter-term bonds. There is a psychological threshold at a 1% difference or 100 basis points between the yield of the 10-year vs. the 2-year note, which suggests extreme confidence in an economic recovery.
Recession prediction model
The New York Federal Reserve created a model based on the yield curve data in the past to assign a probability to a recession or, in the current case, a continued recession 12 months into the future. Instead of looking at the spread between the 10-year note and the 2-year note, this model looks at the yield curve between the 10-year note and the 3-month bill.
NY Fed term spread calculator.
A 19% chance is very optimistic. However, before we rush to load up on SPY call options, it’s important to understand that these predictive models do an abysmal job of factoring in another Black Swan event. While rare, a black swan similar to COVID-19 can send the economy and stock market reeling. We should always understand our net risk exposure and build sufficient downside protection through diversification. To learn more, check out our lesson about diversification strategies.
Outside of shorting the US treasuries, Wall Street takes advantage of a widening yield curve through a curve roll-down strategy. It’s a dead-simple strategy that’s very effective at managing risk and is something that every emerging investor should consider.
The strategy is fairly simple:
- Buy long-term bonds, where the yield curve is the steepest.
- Hold for two years and sell
Why buy bonds over stocks or options?
A few things I’ve written about and cannot stress more enough is risk management. If we take a look at /r/Wallstreetbets, we can see a lot of:
But mostly this:
Some emerging investors are lured by the promise of excessive returns and buy options without realizing the amount of risk exposure they are holding and how quickly downside can destroy portfolios. Hedge-funds exist to hedge away risk and achieve the best risk-to-return ratio, not the highest return.
Jeff Bezos, of Amazon, has an incredible series of interviews where he talks about how he systematically built Amazon into what the company is today. As a startup founder and investor, this interview is exceptionally timely.
So, what you do with those early investment dollars — if you have $300,000 and then you have a million dollars — what you do with those early precious capital resources is you go about systematically trying to eliminate risk. So, you pick whatever you think the biggest problems are, and you try to eliminate them one at a time. That’s how small companies get a little bit bigger, and then a little bit bigger, and a little bit bigger, until finally, at a certain stage, you reach a transition where the company has more control over its future destiny.
While Bezos was describing managing risk for a company, the same principle should be applied as we start building our portfolios. Investing creates disproportional wealth for those who partake through the mechanism of compounding. For compounding to work, it’s crucial to systematically try to eliminate risk from our portfolio—each time we get a negative return, it takes a greater positive return to break even. This forces us to hold more and more risk as we lose, and the result is what we saw above with /r/WSB.
The simplest way to manage our downside and reduce our risk exposure is to invest part of our portfolio in bonds. Because of the inverse relationship, if we get unlucky and hit the 19% chance of recession, our portfolio is saved by rising bond prices as stock prices fall.
Mechanism of roll-down
The current 7-year Treasury yield is 0.46%, and a 5-year Treasury yield is 0.27%. After two years, the 7-year note will become a 5-year note, and the difference in yield would be 0.46% − 0.27% = 0.19%. This difference in yield, assuming the curve remains unchanged, describes the bond price's expected appreciation.
At a glance, a 0.19% return over two years seems very underwhelming. However, remember during this time, we are also collecting the interest payments that add to our return (estimated return = 0.19% + 0.46%+0.46% = 1.11%). Additionally, if the yield curve continues to steepen, then the rolldown increases in momentum, and we can expect much more than 0.19%. If the yield curve flattens and we head into a recession, the bond prices will rise rapidly. This is as close to a win-win scenario as we can get.
Lastly, the example shown here is the US treasury, which is the safest bond with the lowest yield. We can also use this strategy on corporate bonds or bonds issued by companies to borrow money. Last year, Coca-cola issued 5-year bonds with a yield of 1.75%, and Tesla bonds saw a roll-down effect where the yield went from 9.5% to 5.3%. Buying a Tesla bond is a great way to invest in a speculative company while maintaining adequate protection. Bondholders are paid out first before any stockholders. Had we purchased the Tesla bonds, we would be collecting a return of 9.5% a year from the bonds in addition to a 4.2% return in the price appreciation. 💰