They contain all sorts of information, individually and in the aggregate
By R.A. | WASHINGTON, DC
IN 1993 James Carville, an American political operative, quipped that should reincarnation turn out to be real, “I want to come back as the bond market. You can intimidate everyone.” Today, bond markets are more powerful than ever. Traders, politicians and financial journalists keep constant watch over bond yields as they wobble up and down. And when a missed budget forecast in Portugal sends its bond yields soaring, or unexpected murmurs from a Federal Reserve governor cause Treasury yields to tumble, the reaction from all three can be immediate and dramatic. But just what is a bond yield and why does anyone care how it moves?
A bond is a financial security which allows a government or firm to borrow money from markets. Bonds come in many different varieties. The most common sort entitle the owner to occasional interest payments and the return of the principal on a specified maturity date. The governments or firms issuing the bonds typically auction them off, and buyer appetite determines the interest rate the bond carries. Once out in the wild, bonds change hands repeatedly. As they do so the interest payment and maturity dates remain constant, and changes in demand are instead reflected in movements in the price; someone who bought a bond for $1,000 in March might sell it for much more or less in August. Because different bond vintages might carry slightly different coupon payments, markets usually track bond performance by reporting bond yields. The one normally shown in the financial pages is the “yield to maturity”: the rate of return an investor could expect to receive given the price paid and the remaining interest and principal payments due on the bond. When bond prices rise, investors can expect to receive less back in interest and principal as a share of the price paid, and so the yield falls. Falling bond prices, on the other hand, mean higher yields.
So who cares? Bond yields convey all sorts of information. Big changes in the yields on individual bonds typically reflect shifts in the perceived creditworthiness of the issuer. In 2010, when investors grew worried about the Greek government’s ability to service its debts, those holding Greek bonds began selling, and bond prices began falling. Yields soared as a result; indeed, the yield on the bonds of euro-area economies became a key crisis bellwether. Shifting yields apply pressure on the borrower. Heavily indebted governments are often forced to pay off old bonds by issuing new ones; rising yields imply that demand for newly issued bonds will be low unless the interest rate is high—and that the troubled borrower will need to tighten its belt or default on some obligations. Movements in whole classes of yields carry different implications. Bonds are generally seen as less risky than stocks, so a broad decline in bond yields (especially the yields on the safest bonds) can indicate that markets are nervous or pessimistic. Yields might also fall as the return on alternative investments diminishes, herding more traders into the bond market. Investors anticipating a recession or a general slowing of growth might pile into bonds and push down yields in the expectation that stocks and property will do poorly amid the slowdown. Indeed, an “inverted yield curve”, in which the yields on short-term bonds are level with or higher than yields on longer-term bonds, is a trusted recession indicator.
In recent years, bond yields have been behaving in strange ways. The yields on many government bonds have fallen to historically low levels; in some countries, like Germany and Japan, some have actually turned negative. An investor who pays €100 for a 10-year German government bond will receive less than €100 back if he holds that bond until it matures. Such weirdness looks even more bizarre in Japan, where the government has racked up debt worth nearly 250% of GDP: an obligation one might expect to dent confidence in the government’s credit. Some investors blame central banks for these oddities; they have been printing money and buying bonds (raising the price and pushing down the yield) in order to encourage firms to do more borrowing and investing. Others blame a shortage of safe assets, like government bonds, which are increasingly used as collateral in banking systems and as the savings vehicles of choice in emerging markets. Still others see in low yields a sign that the long-run growth potential of the world economy is declining. The debate cannot easily be resolved. But freakishly low yields do suggest that something strange has happened to financial markets, to the global economy, or to both.
