Fixed interest bonds and the yield

Government bonds pay a fixed amount of interest each year (e.g. a £1000 bond might offer a coupon / interest of £40 pa meaning that the interest rate on the bond is 4%).

The price of the bond can and does change after issue because bonds can be bought and sold in the fixed-interest bond market.

The yield on a bond = interest / market price x 100%

So a bond paying £40 interest whose price on the open market rises to £1200 will have a yield of 3.33%

Bond yields vary inversely with the market price of a bond

• When bond prices rise - the yield on a bond falls
• When bond prices are falling - the yield on a bond increases

10 year bond yields for the UK government

The chart above tracks the yield on ten year government bonds for the UK government. 

Interest rate on ten year government bonds for Greece

Bond yields on Italian government debt

Bond yields on Japanese government debt

What factors affect the level of bond yields?

1. Investor demand for a nation's bonds: When domestic and overseas investors have a strong appetite for lending money to a government, the market demand will be high and this means that a government can borrow at low interest rates.
2. Inflation risk - inflation eats away at the real value of a bond which will be paid back in the future. Bond yields tend to be higher in countries with high and volatile inflation because of risks associated with buying bonds in such countries.
3. Default risk - risk-averse investors will buy the sovereign debt of governments with a high credit rating and good economic and political stability - i.e. when the risk of default is low to negligible. By contrast, bond yields are higher in nations where there are fears that the government will find it hard to repay all of their debts - Greece is an obvious example, so too Argentina which has defaulted on sovereign debt in the past and which now finds it more or less impossible to raise new bond finance through international capital markets
4. Rates of return in other investment markets - government bonds are usually (!) low risk investments - few governments actually go bust and most can eventually raise taxes to pay off their debts. When share prices are falling, investors may shift some of their funds into lower risk government bonds, this drives up bond prices and will cause bond yields to fall

Why does the bond yield matter?

1. The interest rate on bonds has a huge effect on the total annual cost of servicing loans. When yields are high, a government will have to pay extra interest to bond-holders and this has an opportunity cost, the money might have been used instead to improve public services
2. Higher bond yields may limit the amount that a government can borrow to fund important infrastructure investment projects
3. If much of the debt is held by overseas investors, interest payments will flow out of the economy, having a negative effect on the balance of payments

BBC News (2012) Bonds, project bonds and Euro bonds

The crisis in the Euro Zone in recent years has focused attention on the importance of the bond markets. Countries such as Greece, Spain, Portugal, Ireland and Italy have all seen - at various times - a surge in bond yields on their government debt. When yields rise above a crucial level (see by many as anything above 6%) then it becomes very expensive for a government to borrow new money.

The good news is that bond yields in Spain, Portugal, Ireland and Italy have been falling sharply in recent times. Partly this is because of a sharp drop in the rate of inflation (which itself brings fears of deflation) but also because the governments in these countries have achieved significant improvements in their own finances (i.e. lower budget deficits) and this has helped to restore investor confidence.

Understanding bond yields (useful video - well explained)