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Sunday 11 March 2012

Why are Bond Yields Low? - Part 1



Bond Yields

Before considering whether bond yields are high are low, it is important to understand what the bond yield reflects. A brief overview can be found in this previous post , but in summary they reflect the annual return that you should expect to receive (assuming the issuer default) from now until they mature. This is comprised of coupon payment made to the buyer of the bond (often semi annual), and any capital gain/loss that may occur as the bond moves towards its maturity value (e.g. $1000, 100,1000). A bond can therefore have the same yield by either paying a small coupon, and currently trading well below its maturity value (large capital gain from now until maturity) or by having a high coupon payment, and a small capital gain component.

The yield on a bond is the return that the investor expects to receive given the risk that the issuer of the bond may default on their payment. For example, if I am buying a bond from the US government, it is highly unlikely that they will default, as they can simply print more money to pay off their debts. If I am getting a 2% coupon each year, the bond may trade close to its maturity value, meaning my overall yield is 2%. However, if I bought a bond from a struggling nation such as Portugal, with the same annual 2% coupon, I may be willing to only pay 50% of the maturity value since they have a higher risk of default. This would increase your yield to maturity, and supports the theory that investors always demand a higher return for an asset with higher risk.

So Why are Yields Low?

In every country there is a rate known as the risk free rate of return, which is usually the rate set by the Central Bank (4.25% is the cash rate in Australia, in the US it is essentially 0%). If you buy a bond which you believe has no default risk, the yield will only rise if you believe the risk free rate of return will also increase over the lifetime of your bond. If company bond yields always trade 5% above government bond yields, to reflect the increased chance of default, then if the risk free rate in that country increases by 1%, the yield on the corporate bond should increase by 1%, assuming nothing else changes. Here’s a chart of the yield to maturity of US 10 year Treasury Notes (bonds with shorter maturities).


In the US, 10 year notes are trading just above 2% and have been for a while. Before the GFC, when the Federal Reserve (central bank) set their risk free rate much higher than 0%, the yields on 10 year notes were closer to 5%. Given what you’ve read above, and in the previous article, can you explain why? Have a think, write down your answer, post it below if you like. I’ll write the answer later next week, just to encourage some individual thought, and see if you’re right. If you are, you’re a step closer to understanding financial markets well enough to look at trading them.

In the pipeline: Why are bond yields low? – part 2

Bullish on: Gold price (performs well when inflation is a concern and countries are buying it in record quantities)

Bearish on: US 10 year Treasury Notes (yields are too low, prices will fall on inflationary concerns and an economic recovery)

As always, please leave any comments or questions that you have and I’ll get back to them as soon as possible. If you are looking for more trading strategies, try some of the articles at www.pimmtrading.blogspot.com.

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