A look at factors that determine bond yields.
- Firstly, bond yields have an inverse relationship with the price of bonds.
- If demand for bonds rises (and therefore price of a bond goes up), the yield goes down.
- A £1,000 bond that has an interest rate of 5% – means the government will pay £50 interest payment every year.
- If the price rises, the effective yield falls. If you buy that bond for £1,600, effectively the yield is 3.1%
- Therefore, if demand for bond rises, the price of bonds goes up and the yield goes down.
- If demand for buying bond falls, the price of bonds falls, causing higher interest rates and yields
- See also Relationship between bond price and bond yields
Summary of factors that determine bond yields
- Is default likely? If markets fear the possibility of government debt default, it is likely they will demand higher bond yields to compensate for the risk. If they think that a country will not default but is safe, then bond yields will be relatively lower. It is worth mentioning debt default is relatively rare in developed economies (except issues in Eurozone)
- Private sector saving. If the private sector has high levels of savings, there will tend to be a higher demand for bonds because they are a good way to make use of savings, and yields will be relatively lower. Savings tend to rise during periods of uncertainty and low growth.
- Prospects for economic growth. Bonds are an alternative to other forms of investment like shares and private capital. If there is strong economic growth, then the prospect for shares and private investment improves, therefore bonds become relatively less attractive and yields go up.
- Recession. Similarly, a recession tends to cause a fall in bond yields. This is because, in times of uncertainty and negative growth, people would rather have the security of government bonds – than more risky company shares.
- Interest rates. If Central Banks cuts base interest rates, this will tend to reduce bond yields as well. Lower interest rates on bank deposits make people look for alternatives such as government bonds.
- Inflation. If markets fear inflation, then inflation has the capacity to reduce the real value of the bond. If you borrow £1,000 now but have inflation of 20% for the next 10 years, the £1,000 bond will rapidly decrease in value. Therefore, higher inflation will reduce demand for bonds and lead to higher bond yields.
Examples of changing bond yields
- Eurozone crisis
This graph shows bond yields for four countries between 2007 and 2013.
Since 2007, UK bond yields have fallen. This is primarily due to the fact that since the recession, there has been a sharp increase in private sector saving and therefore higher demand for relatively ‘safe’ investments, such as government bonds.
Bond yields in Spain and Italy rose because of market fears over possible debt default and illiquidity in the bond market. Because Spain was in Eurozone, they did not have a lender of last resort. (Central bank to create money and buy bonds if necessary). This is why bond yields rose – investor fears rising debt levels could not be financed.
Note: Since this period, bond yields in Spain and Italy fell because the ECB has become more willing to intervene in the bond market.
