UK bond yields are the rate of interest received by those holding Government bonds.
Governments sell bonds (via the Debt Management Office DMO) to fund their budget deficits. Bonds are a way for the government to borrow – a bit like the government taking out a loan.
Government bonds are frequently traded on bond markets. Therefore, their market price may be quite different to the original price set by the government.
Example. A government may sell a 10 year, £1,000 bond at 5% interest. This means every year year the government will pay £50 to the holder of this bond.
- If demand for government bonds rose, this £1,000 bond would increase in price as investors pushed up the market price.
- But, the government still pay £50 a year interest until maturity. If the market price of the bond rises to say £2,000, the interest rate (yield) is now 2.5% (50/2000)
- Therefore higher demand for bonds leads to lower bond yields.
- Conversely if people sell bonds, this pushes up the bond yield (e.g. what happened in Greece)
Recent UK Bond Yields
Source: Bank of England – 10 year bond yields
Despite higher government borrowing, bond yields have fallen.
What is the importance of bond yields?
- Cost of Government Debt. If bond yields fall then the government can issue debt at low interest rates. This makes it cheaper for the government to borrow. The UK spent around £45bn on interest payments in 2011/12. If bond yields were higher, this interest rate cost would be much greater. Countries like Spain and Italy with high bond yields have to spend a large % of tax revenues on just interest payments, making it difficult to reduce government debt.
- How Much Can a Government Borrow? If interest rates are low, this is an indication markets are willing to buy government debt. Therefore, the government can borrow more. If bond yields rise sharply, this indicates the private sector no longer wish to buy government bonds, and therefore the government will face much greater pressure to reduce borrowing soon.
- Forecast of future growth and inflation. Low bond yields may indicate unwillingness to invest in private sector investment and reflect low growth.
- Future Inflation. Bond Yield curves can indicate future inflation trends. (see below)
Why have UK bond Yields fallen in the recession?
In some Eurozone economies, bond yields have risen very rapidly because of fears over government debt. The UK has very high annual borrowing (2011/12 annual deficit – nearly 10% of GDP). Yet in the UK bond yields have fallen. This is because:
- Increase in savings rates. Higher private sector savings have increased demand for secure assets such as government bonds
- Poor returns in private sector. Double dip recession has made investing in private sector less attractive. Investors would rather have security of government bonds with low interest rate than riskier shares and private sector investment.
- Q.E. The policy of Q.E. and purchase of government bonds by Bank of England has helped keep bond yields low.
- UK seen as safe haven compared to Eurozone economies like Spain, Italy and Ireland.
- UK has independent monetary policy and exchange rate. A big reason UK yields are low is that we are not in the Eurozone, but have their own currency and can create more money if necessary. There are no fears of a liquidity crisis in the UK because the Bank of England can always print money if necessary. Eurozone economies don’t have a Central Bank willing to do this – so have been more susceptible to investor concerns.
See also: Factors that determine bond yields
History of UK bonds since 1984
This shows the bond yield on 10 year government bonds since 1993.
Higher bond yields in the early 1990s are a reflection of higher inflation rates. Investors needed a higher yield to compensate for inflation eroding the value of savings.
Bond Yield Curves
These show the interest rates for bonds of different maturities. Usually, 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.
Spread on Bond Yields
- 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%.
UK Instantaneous Implied Inflation Curve
Source: B of E bond yield curves
Implied inflation from looking at bond yields