What are bond yields?
22 Dec 2021
Those who follow financial news will have likely heard of bond yields, but for some investors this terms can often seem bewildering. So, what are bond yields and why do economists follow them so closely?
What is a bond yield?
A good place to start when trying to wrap your head around the concept of bond yields is with some basic knowledge of bonds and yield.
So, what is a bond? A bond is a debt instrument whereby investors can loan money to corporations and governments for the benefit of collecting interest. Think of it as an interest-only loan. When the bond is first issued its price is known as the face value. The annual interest paid to investors is a percentage of this price, and this price is fixed.
In investments, yield refers to how much an investor is being paid from their investments as a percentage of the asset’s current value. Therefore, bond yield refers to the interest investors receive from the bonds in relation to the value of the bond.
Why does the yield change?
During the lifetime of a bond, (ie. before its maturity date) bondholders can sell their bonds and, depending on demand, a bond’s value can fluctuate. This can impact the yield of a bond. Here’s a hypothetical example: Let’s say, Sally has purchased a bond with a face value of $500 and with an interest rate of 5% and maturity date of 10 years. Therefore, the bond pays Sally $25 each year for the next 10 years. However, two years in, Sally is now looking to sell her bond. Demand for bonds is low, therefore the price of her bond has fallen to $450, but as the coupon payment (ie. the $25 payment) is fixed, the new bond holder would receive a more attractive yield at 5.5%.
Why do investors care about bond yields?
Typically, when bond yields are on the rise it means that investors are selling bonds with the expectation that interest rates will increase, and they can likely get a better return on other investment products. Conversely, when bond yields are falling it generally means investors are buying bonds expecting interest rates to fall. Bond yields and prices can also be affected by investor’s expectations about inflation and economic growth.
The yield curve
Another way the bond yields can be helpful to investors is by looking at their trajectory. This is where the yield curve comes in, another term you may be familiar with. The yield curve is a graphical representation of the interest rates (i.e the yield) of bonds from the same issuer or with the same level of risk, but over various maturity dates.
Any series of bonds can create a yield curve, although to get the yield curve, the one reported and referred to in the news, you have to look at US Treasury bonds.
You may be thinking: what does the US Treasury bond yield have to do with Australia? Well, the yield curve is used by some in the finance industry for its predictive quality; it has historically reflected the market’s sense of the US economy. Depending on the shape and severity of the curve it has been known to suggest a recession is on the cards. And a recession in the US would likely negatively affect the Australian economy.
Related article: 4 Ways to buy bonds in Australia
Three different types of yield curves
There are three different types of yield curves: normal, flat or inverted.
All the examples below are fictional and for the purpose of illustrating the different yield curves.
Normal
When the yield curve is sloping upwards it is considered normal. A normal yield curve occurs when short-term interest rates are lower than longer-term interest rates. Which is typically the case, as the longer you hold your bond the riskier it can be. Therefore, to compensate, bonds with a longer maturity date generally have a higher interest rate. Here’s a hypothetical example:
For some investors, a normal yield curve is an indication that the economy is generally going well and the future outlook is positive.
Flat
When the yield curve is flat, short-term interest rates are similar to long-term interest rates. This generally occurs when demand for bonds with a longer maturity date is high, thus pushing the interest down for long-term bonds. Here’s a hypothetical example:
This can be a warning sign of economic troubles ahead. This can suggest investors feel there are greater risks elsewhere on the market that outweigh the risk of a long-term bond.
Inverted
An inverted yield curve occurs when short-term interest rates are higher than long-term interest rates. For some investors, this is where the alarm bells really start to ring. If investors are rushing into long-term government bonds, it can be an indicator that concern over the economy is high. Therefore, investors are willing to accept lower returns on long-term bonds to ensure they have a source of interest in the future.
What can you do with an unfavourable yield curve?
By no means is the yield curve an exact science. So, when the yield curve is flat or inverted it doesn’t mean you should panic. Instead, what you can do is ensure your investment portfolio is well diversified. This could mean that your investments are spread across different countries, assets and industries. Also worth doing is to have a back-up fund in case the economy does take a downhill slide.
Finally, investing should be enjoyable and rewarding. If you are not finding this to be the case, ensure that your investments match your risk tolerance.
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This article was reviewed by our Content Producer Isabella Shoard before it was updated, as part of our fact-checking process.
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