Bonds can be highly sensitive to interest rate movements. When a given central bank decides to raise interest rates, it quickly translates into higher yields on the nation´s sovereign bonds.
As there is an inverse relationship between yield and price, higher interest rates lead to lower bond prices. In the opposite direction, lower interest rates push up prices.
Yield changes on government bonds also ultimately impact the yields found in other bond market segments.
The constituents of the global bond market can be thought of as lying along a risk spectrum. At the lowest end of the risk spectrum are the major government bonds, such as US Treasuries and German bunds.
Government bonds such as US Treasuries are so low down on this risk spectrum that economists have historically referred to the yield they generate as representing a “risk free rate”. It´s virtually inconceivable that the US government would ever default on its debt obligations.
10-year US Treasuries, bonds issued by the US government with ten years until their maturity, currently have a yield of just 2.2%.
In July 2007, just prior to the financial crisis, the 10-year US Treasury yield was a little over 5%, a level that had been historically thought of as a reasonable long-term average for the risk-free rate.
Yield hungry investors
The ultra-low official interest rates witnessed in the aftermath of the 2008/2009 financial crisis also pushed down the yields on offer from corporate bonds, as yield hungry investors competed to secure higher yields.
Over recent years, time and again companies have found that their bond issues are well oversubscribed. This has enabled them to issue debt at lower yields than they had even hoped for.
For example, US technology group Qualcomm recently issued debt at a 105 basis points spread above the 10-year US Treasury rate. In other words, it is paying investors a yield just 1.05% higher than that paid by 10-year US Treasuries.
The implication is that corporate bonds are being issued at rates lower than what was previously considered to be the risk-free rate. Of course, corporate bonds are certainly not risk free. There is always a chance that a corporate bond issuer could default on their debt obligations.
Bonds as an asset class are often collectively referred to as “fixed income”. This is because the governments or corporations that issue bonds pay a fixed annual level of interest to bondholders.
However, the yield is calculated by dividing the total annual coupon payments by the price of the bond. As bond prices fluctuate in the market on a daily basis, so do the underlying yields.
Suppose a central bank decides to raise official interest rates. Investors know that the yield on the face value (the value when the bonds are issued) should be higher the next time the nation issues bonds. This naturally pushes down the prices of the existing sovereign bonds already in the market as investors expect higher yields.
Be it for UK gilts, German bunds or US Treasuries, the shape of the government bond yield curve provides a snapshot of market expectations on future interest rates.
With a normal yield curve, yields increase as bond maturities get longer. Theoretically, investors require a higher yield when there is longer to wait until a bond´s maturity.
A normal yield curve can also become steeper when there is increased demand for the shorter-dated bonds.