Bonds and Yields
Governments sell bonds to fund their budget deficits. They are a way for the government to borrow – a bit like the government taking out a loan.
UK bond yields are the rate of interest received by those holding Government bonds. Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula; Bond yield = coupon amount/price.
When you buy a bond at par, yield is equal to the interest rate. The coupon always stays the same, but the price of the bond will change from par as it is traded in the open market – so therefore the yield will change.
- Assume you bought at bond at par when interest rates were 5%. The market value of your bond will fluctuate after your purchase as interest rates rise or fall.
- Let’s assume that interest rates rise from 5% when you bought your bond at par $1000 to now 7%. Because new bonds are now being issued with a higher coupon of 7%, your bond, which has a 5% coupon is not worth as much as it was when you bought it. In this case, the value of your bond would be less than $1,000. Hence, your bond would be trading at a discount e.g. $990.
- Conversely, if interest rates were to fall after your purchase to say 4%, the value of your bond would rise because investors cannot buy a new issue bond with a coupon as high as yours, so your bond may rise in price to e.g. $1100.
What will happen for current bonds in the market is that they will continue to increase/lose their market value until the yield on them (coupon/market value of the bond) is the same as current bonds being issued at par.
Rising interest rates are bad for current bondholders as the bonds lose their market value, so if you think there may be an interest rate rise it is best to sell your bond now.
Interest rate rises are good for potential bond buyers as they get a better coupon when they buy the bond.
When there is a bad economic event e.g. high unemployment or recession or some event that could affect stocks, people tend to take their money out of risky assets such as stocks and put them into safer assets like government bonds. As more money and more demand comes in for these bonds, the price of the bonds increase (coupon remaining unchanged), resulting in lower bond yields. This also results in appreciation in the country’s currency. With lower market produced bond yields, the government can issue debt at low interest rates and thus making it cheaper for the government and small companies to borrow and grow/expand to get the economy moving again. Low bond yields reflect low market confidence.
Once bond yields start to increase sharply i.e. people are selling the bonds heavily and driving the bond price down – this means people are no longer wishing to invest in the bonds at the current yield and seek to invest in higher yielding assets such as stocks – signalling that the economy is due for growth. High bond yields reflect high market confidence. Higher bond yields weaken the country’s currency.
On the other hand, rising yields on bonds can result from the bond being risky and losing its value as investors sell the bond for fear they may not recoup their investment or the bond issuer may default. In some Eurozone economies, bond yields have risen very rapidly because of fears over government debt eg. Greece.
Rising bond yields give off the impression of potential higher inflation as investors demand a higher yield (a low price vs the coupon today) to compensate for inflation eroding the value of their savings.
Spread on Bond Yields
Bond yields on short term debt (1 year or less) are low.
Bond yields on longer term debt (20,30 years) are higher. This is to reflect increased risk and likelihood of inflation in the long-term and the fact that there is more chance of an interest rate rise to combat this inflation – which brings down the market value of the bond. Bonds with higher coupons are better insulated against rising interest rates.
The spread is the difference between the yield on a long term bond and a short term bond. For example, if a 30-year bond pays 5.00% while a 1-year bond pays 3.55%, the spread is 1.45%.
In the UK bond yields have fallen even though the UK is highly leveraged. This is because:
- Double dip recession has made investing in private sector less attractive. Investors would rather have security of government bonds despite the low interest rates than risk their money on shares and in the private sector – thus pushing the price of gov bonds up.
- The policy of Q.E. and purchase of government bonds by Bank of England has helped push gov bonds price up and keep bond yields low.
- UK is seen as safe haven compared to Eurozone economies like Spain, Italy and Ireland.
- UK has independent monetary policy and exchange rate and we can create more money if necessary – so no fears of a liquidity crisis in the UK and therefore bond investors don’t mind paying a higher price for the bond.
How Yields Work
Gilts are a promise by the Government to pay interest on money lent to it for a set period of time. Those who buy gilts know that there is no real prospect that they won’t get their money back because, even if the Treasury’s reserves are empty, the government can print more money to repay its debts.
Interest rates up > Bond Prices fall > > Yields up
Interest rates down > Bond prices up > Yields down
If there is uncertainty in the market, investors will not buy risky assets and instead go to buy government bonds which drives the prices up. (yields down)
If you think there will be less growth, hence less potential inflation and therefore less chance of an interest rate rise you will buy government bonds which drives the prices up (yields down).
A fall in yields tells us that investors value the protection offered by gilts more highly and therefore demand for these bonds increase, which pushes the prices up.
A rise in yields would conversely signify there is less demand for bonds so prices are being pushed down as people seem to be more bullish i.e. think there is more chance of growth happening, inflation rising and there will be an interest rate rise coming.
Yields today Yields have been falling ever since central banks cut interest rates in the wake of the financial crisis as people have been moving more and more towards long term gilts.
Provided that they are held until the bonds mature, the only realistic risk that investors face in buying gilts is that inflation is so high that it erodes the value of their money and that the interest rates they have locked into fail to offset this.
As things stand in the current economic climate, to invest with the government for 10 years and demand only around 1pc a year in return suggests markets don’t believe that inflation and growth are going to accelerate any time soon. In Britain, any rate rises have been put on hold as the picture for the global economy has deteriorated.
In Britain, the extra uncertainty that leaving the EU would bring has lowered expectations of a rate rise.
INTEREST RATES & EFFECT ON ECONOMY
Each currency carries with it an interest rate. This is almost like a barometer of that economy’s strength or weakness.
As a nation’s economy strengthens over time there is more money supply and we have more disposable income allowing us to buy more things for our currency. Prices tend to rise as consumers are able to spend more of their income and the rise in prices is called inflation because companies are able to charge more for their produce.
If inflation is allowed to run rampant, our money will lose much of its buying power and ordinary items such as a loaf of bread may one day rise to unbelievably high prices. To stop this danger before it emerges the central bank steps in and raises interest rates in order to stem inflationary pressures before they get out of control.
Higher interest rates make borrowed money more expensive, which in turn dissuades consumers from buying things and also discourages corporations from expansion. If rates get too high, the central bank will step in again and lower interest rates to encourage growth. The Central Bank has a delicate balance of trying to foster growth while at the same time keeping inflation low.
High interest rates are good because it attracts foreign investors who desire to invest in that country and the returns on its currency through depositing money within its banks. Consequently, there is an increased demand for that currency as investors invest where the interest rates are higher and causes the currency’s value to rise.
The direction of the interest rate can act as a good proxy for demand for the currency. High and increasing rates at the beginning of an economic expansion can generate growth and value in a currency. On the other hand, low and lowering rates may represent a country experiencing difficult economic conditions which is reflective in a reduction of the currency value.
Countries that offer the highest return on investment through high interest rates, economic growth, and growth in domestic financial markets tend to attract the most foreign capital.
The expectation of future interest rate increases or rate cuts is even more important than just the actual rates themselves.
GDP should not be high enough to trigger inflation or too low where it could lead to recession (two consecutive negative quarters of GDP growth) and deflation. Central banks are there to control this.
The most obvious danger of too-low inflation is the risk of slipping into outright deflation, when prices persistently fall. Deflation is both deeply damaging and hard to escape in weak economies with high debts. Since loans are fixed in nominal terms, falling wages and prices increase the burden of paying them. And once people expect prices to keep falling, they put off buying things, weakening the economy further.