SINCE THE ECONOMIC crash nearly a decade ago, bond yields have never been too far from the headlines.
Irish 10-year bond returns hit record lows this week, flirting around the 0.32% mark on Wednesday, a far cry from the more than 14% return on offer to investors when the economy was self-combusting in 2011.
Meanwhile, UK bond yields actually dipped into negative territory after the Bank of England promised to put money aside to buy up bonds as part of its stimulus measures announced last week.
But what is a bond yield, why do they rise or fall and – most importantly – why should anyone care?
What are bonds?
A bond is essentially an IOU that is given by a company or a government to a lender.
Bonds tend to be used as a method for raising cash by large entities, like governments, which need regular sources of funds.
People don’t buy bonds out of the goodness of their own hearts though, they’re in it for the return. That’s why any organisation that gives out the bond will also issue a coupon with the bond – and that coupon essentially represents the interest they will be paid on the IOU.
For example, if Kevin bought a 10-year bond that had a face value of €1,000 and a coupon of 5% from Acme Corp, he would receive €50 of interest per year from Acme for the next decade.
Then, once the 10 years has elapsed and the bond reaches what is known as its maturity date, Kevin will also get the full face value of what he has loaned to Acme back – in this case €1,000 – as long as he still owns the bond.
It’s important to remember that buying bonds is very different to buying stocks. Bonds are classified as debt, whereas stocks are equity. If you have bought a bond from a company, that doesn’t give you a stake like a share does.
However, the upside of being a bondholder as opposed to a shareholder is if the business or government was to go bankrupt, you stand a better chance than a shareholder does of recouping the money you lent. See Irish banks and the infamous ‘burn the bondholders’ debate.
But bondholders don’t have to hold onto bonds until their maturity dates. Sometimes they like to cash out and sell their bonds. This is where bond yields come into play.
So then, what are bond yields?
Essentially, a bond yield is the return on a bond you have bought, however in this case can go up and down based on what price someone is prepared to pay. This is where it starts to get more complicated - and why you start seeing ‘bond yield’ and maybe ‘economic meltdown’ in the same headline.
Before we get into what makes bond yields change, let’s clear up how a yield is calculated. The technical formula is: the coupon amount divided by price equals yield.
So the bond Kevin bought off Acme for €1,000 has a yield of 5%, but if the price of the bond went down to €800, then the yield for a buyer would be 6.25% – that is based on them getting the same €50 back on the new value.
When the prices for bonds go down, yields go up. And vice versa. But what makes bonds fluctuate in price to begin with? The reason why bonds change in price is a little bit different to why prices stock markets jump up and down.
Bond prices, and in turn bond yields, can change in reaction to interest rates, which are set by organisations like the European Central Bank, and measures taken by governments to stimulate an economy.
For example, UK government bond yields have fallen in reaction to the announcement by the Bank of England that it would buy government bonds as a move to boost the British economy.
As the government-driven demand increases, the price should fall – which has the knock-on effect of making it cheaper for institutional borrowers like major corporations to get hold of credit.
Bond prices are also affected by credit ratings, which are an assessment of the risk associated with loaning money. So the higher the credit rating, generally the easier and cheaper it is for borrowers to attract buyers for their bonds.
Germany, one of the gold standards when it comes to government bonds, has a triple-A credit rating and can currently borrow money for all but the longest periods at negative rates – meaning people are effectively paying to lend it money.
Why are Ireland’s bond yields so low?
Ireland’s bond yields have hit record lows this week – and there a number of factors pushing the rate down.
Bond prices are increasing (and remember, yields fall when this happens) because central banks have been slashing interest rates left, right and centre.
The ECB’s rates have been at record lows since late 2015, while the return on its main deposit facility has been at or below 0% since mid-2012.
Another issue is the scarcity of bonds on offer, another symptom of central banks hoovering up all they can to drive down prices. The Bank of England recently failed to hit its bond-buying target – this first time this had happened since it began snapping up the assets in 2009.
Ireland’s credit rating has also been on the march back to respectability, earlier this year recovering its coveted A grade for the first time in half a decade as the economy recovers.
That means the country’s bonds – or government debt – are seen as a lower risk, which means borrowers don’t expect the same return as when buying bonds from a country with shaky economic foundations.
Gilt-edged investments like Germany and the Netherlands currently have negative bond yields, which makes countries on the periphery of the eurozone – like Ireland – appear more attractive options, despite the rock-bottom returns.
So that’s good news for the Irish government and taxpayers, as lower borrowing costs mean less money going to pay interest and more money to spend on everything else.
Written by Killian Woods and posted on Fora.ie
To embed this post, copy the code below on your site
have your say