The bond market, yields and risk: how they work

PARIS, August 18, 2013 (AFP) – The market for debt issued by governments is huge and global, and it provides benchmarks for interest rates across national economies, in addition to official central bank rates. The market is known as the sovereign debt market, or the fixed income market.

This is because most government debt is issued with fixed annual cash returns for the life or maturity of the debt instrument, called a bond.

The fulcrum of the global bond market is the US Treasury bond market, and the main barometer of this is the yield on US T-bonds issued with a life of 10 years.

This means that the bond will be redeemed, and the money lent to the government will be repaid together with the last payment of interest, 10 years from the date of issue.

In the eurozone bond market, the reference bond is the 10-year German Bund because it is considered to be the safest and carries the lowest rate of return, or yield.

Central banks set base interest rates for funds provided in the short term to the banking system.

But businesses, individuals, and also governments needing to borrow money, from the very short term up to many years, have to borrow from the national and international pool of funds available for investment, called savings.

Governments need to borrow, particularly when annual revenues fall short of annual expenditure, including the cost of paying interest on existing bonds and redeeming bonds falling due.

Such a situation generates an annual budget, or public, deficit.

To bridge the gap, a government will create bonds and offer them for sale, if it has the credit-worthiness to do so at an interest rate the nation can afford.

The bonds are auctioned for sale on the primary, or new-issue, market. They offer a fixed amount of cash return each year which should be competitive bearing in mind the credit rating of the country and the overall climate for interest rates.

The terms on which investors bid to buy the bonds then determine exactly how the annual cash return relates to the price of the bond, generating an interest rate at issue.

The bonds may then be traded throughout their life on the secondary market.

If the perceived risk of lending money to the country concerned, goes up, some investors will sell the bonds already issued, and some investment funds may be obliged to sell under their contracts with savers if the rating on the bond falls below certain levels.

This will depress the price of the bond: the annual cash return, the yield expressed as a percentage of the new lower price, automatically rises.

The same process works in the opposite direction: if risk falls, the price of the bond rises, and the percentage yield falls.

Hence, bond prices and yields move in opposite directions. In general, the climate of exceptionally cheap money from central banks during the financial and debt crisis is believed to be ending: the landscape of low rates and low risk is moving up the scale.

Hence, bond yields are tending to rise as well, and bond prices on the secondary market to fall.

Government bonds are an essential component of many financial organisations.

For example, pension and insurance funds need them for low-risk income, and banks need them if only to offer as guarantees when borrowing short-term refinancing from the central bank.