Tuesday, July 21, 2009

Rising Bond Yields

To finance government debt, governments sell bonds which pay interest (yield). E.g. a government may sell a £100 bond at an interest rate of 5%.

These bonds could be held to maturity anything from 3 months to 30 years. However, many bonds are bought and sold on financial markets causing price and yield to change. The price and yield of bonds give various indications of the state of the economy.

Firstly, if bond prices rise, yields decline. If bond prices fall, the yield rises. There is an explanation why here.

  • Since last autumn the yield on the 10-year US Treasury bond has risen from just over 2pc to almost 4pc.
  • UK Bond yields on 20 year and 30 year bonds are currently 4.75% (source: Government bonds at Bloomberg)

Thus rising bond yields means investors are less willing to hold government bonds. More people are selling bonds causing price to fall and yield to rise.

Why Bond Yields are Rising.

Bond Yields can rise for a variety of Reasons.

1. People prefer riskier assets such as shares. (the recent rise in the stock market suggests some are switching from safe bonds to riskier shares)

2. There is fear of future inflation. If investors expect inflation to increase in the future, they will demand a higher interest rate (yield) to compensate for the decreased value of money in the future. Higher inflation may be feared because of:
  • economic recovery
  • Oil price shock.
  • Quantitative easing to increase money supply
3. There is fear Over Government Ability to Repay debt. If investors start to doubt the safety of government debt they will require higher interest rates for the risk premium. This is a cause for concern government debt around the world is rising sharply, if markets worry governments are too indebted, yields on debt will rise making it more expensive to finance.

4. High levels of debt High levels of debt tend to reduce yields as more bonds are sold onto markets. The policy of quantitative easing is buying up some of these extra bonds. In theory this should push up prices and push down yields. But, quantitative easing also raises inflationary expectations.

Should We Worry about Rising Bond Yields?

  • In a recession with a threat of deflation, bond yields are very low. If Rising bond yields are a sign of economic recovery and a return to normality, then this is a good sign.
  • The aim of quantitative easing is to avoid deflationary pressures, therefore, if it is successful in avoid deflation and pushing inflation to more normal levels again we would expect this to have an effect on bond yields.
  • If rising bond yields are because the government's credit rating is deteriorating, then this is a real cause for concern. It means it will be more difficult and expensive for governments to finance their large budget deficits in the future.
  • Higher bond yields may push up long term interest rates on corporate bonds and mortgages. These higher interest rates will have the effect of slowing down economic growth and investment.
The big question is then are rising bond yields due to economic recovery or worries over government debt? At the moment, the markets are giving the governments the benefit of the doubt. Although bond yields have risen from the record lows they are still relatively low by long term standards. However, with future deficits expected to be very high, this could change in future.


1 comment:

bdforbes said...

You state that "High levels of debt tend to reduce yields as more bonds are sold onto markets". If there are more bonds on the market, won't the price go down (i.e. basic supply and demand), and thus the yields should increase?