What drives the yield of gov­ern­ment bonds?

Financial Mirror (Cyprus) - - FRONT PAGE -

Due to the cur­rent weak eco­nomic cir­cum­stances that we are ex­pe­ri­enc­ing here in Cyprus (as well as other coun­tries in Europe), we are con­stantly bom­barded with var­i­ous eco­nomic and fi­nan­cial terms from the media, most of them un­known to the gen­eral public.

One of them





the gov­ern­ment bonds (of Cyprus, as well as other na­tions around the world). From the nu­mer­ous times that we hear this term, one can un­der­stand that it is very im­por­tant and can af­fect sub­stan­tially our econ­omy’s path, but does the av­er­age per­son (and not a so­phis­ti­cated in­vestor) know ex­actly what this means, or how is de­com­posed, or what drives its fluc­tu­a­tions?

The pur­pose of this short ar­ti­cle is to ex­plain in sim­ple terms the above rel­e­vant ques­tions.

The yield (or re­turn) to ma­tu­rity is the av­er­age an­nu­alised rate of re­turn of hold­ing the bond un­til ma­tu­rity, pro­vided that the is­suer (gov­ern­ment in this case) does not de­fault (misses an in­ter­est pay­ment, or re­struc­tures its debt). This re­turn is an out­come of the pe­ri­odic coupon pay­ments (usu­ally ev­ery six months), the cap­i­tal gain (or loss) when the bond ma­tures or is sold, and the in­ter­est in­come that is gen­er­ated from the rein­vest­ment of cash flows.

One can think of this re­turn as a sum­ma­tion of the real risk-free rate (i.e. the rate of re­turn on a risk-free se­cu­rity, ex­clud­ing the im­pact of in­fla­tion), an in­fla­tion pre­mium (i.e. a rate of re­turn that ac­counts for the ex­pected in­fla­tion in the econ­omy), as well as risk premi­ums from other sources of risk (mainly credit and liq­uid­ity risk). The real risk-free rate and the in­fla­tion pre­mium to­gether con­sti­tute the nom­i­nal risk-free rate of re­turn.

If we com­pare the yields on Eu­ro­zone gov­ern­ment bonds one can ob­serve that the dif­fer­ences in terms of credit and liq­uid­ity risk among var­i­ous coun­tries leads to dif­fer­ent lev­els of prices and yields (the higher the risk, the higher the yield). One should also un­der­stand that there is an in­verse re­la­tion­ship be­tween prices and yields (i.e. the higher the yield, the lower the price that the bond is traded). media, do not stay con­stant but are timevary­ing. Why is that?

First, as the bond moves to­wards ma­tu­rity, its price moves closer to the prin­ci­pal amount and there­fore the yield will ac­cord­ingly change. A sec­ond rea­son is a change in the credit qual­ity of the is­suer by the credit rat­ing agen­cies, while a third is a change in the yield on com­pa­ra­ble bonds (i.e. of the same credit qual­ity).

To high­light the sec­ond rea­son, when the credit qual­ity of the Cyprus gov­ern­ment was de­te­ri­o­rat­ing prior to the March 2013 events, we had sub­se­quent and mul­ti­ple down­grades by the rat­ing agen­cies which in­creased the yields to lev­els that were pro­hib­i­tively high to bor­row. I should note here that yields can also change be­cause of changes in risk level, with­out any ac­tion by the rat­ing agen­cies.

Fur­ther­more, if you look at what is hap­pen­ing now across the Eu­ro­zone and yields on com­pa­ra­ble bonds, they have been go­ing down mainly be­cause of the ex­tremely low base in­ter­est rates ap­plied by the Euro­pean Cen­tral Bank (ECB) as well as the Quan­ti­ta­tive Eas­ing (QE) pro­gramme of Mario Draghi that be­gan last March. The QE pro­gramme in­creases the money sup­ply in the Euro­pean econ­omy and thus the de­mand for fi­nan­cial (or other) prod­ucts (in­creas­ing their price, and low­er­ing their yield). It also has the added ef­fect of send­ing pos­i­tive sig­nals to the mar­ket that the ECB stands ready to do what­ever it takes to pre­serve the sta­bil­ity of the com­mon cur­rency and as­sist in bring­ing back growth to the prob­lem­atic Eu­ro­zone econ­omy.

As pointed out above, changes in yield lev­els shape and af­fect the eco­nomic prospect of whole na­tions, thus they are very im­por­tant. The aim of course from the per­spec­tive of the is­suer is for them to be as low as pos­si­ble so that they lower the cost of fund­ing. One ef­fec­tive way of do­ing that is through fis­cal con­sol­i­da­tion and the nec­es­sary re­forms to mod­ernise the econ­omy and make it more com­pet­i­tive.

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