Bond yields rarely make the front page, yet they influence everything from mortgage rates to share prices. Here’s how bonds work, and why investors watch them so closely.
A bond is a loan. When you buy a bond, you are lending money to the government or company that issued it.
In return, the issuer usually pays a fixed amount of interest, called the coupon, at regular intervals, and repays the original amount, called the face value, on a set date known as maturity. Governments use bonds to fund spending, and companies use them to raise money without issuing more shares.
In Australia, the federal government’s bonds are called Australian Government Bonds, or Commonwealth bonds. In the U.S., government bonds are known as Treasuries. Because these governments are considered very unlikely to default, their bonds are seen as among the safest investments, and they’re held in large amounts by super funds, banks and central banks.
Once issued, bonds trade between investors, and their prices move up and down every day.
Why yields rise when prices fall
The yield is the return an investor gets if they buy a bond at today’s price and hold it to maturity.
Because a bond’s interest payments are fixed, its price and its yield move in opposite directions. If a bond pays $5 a year on a $100 face value, and its price falls to $90, a new buyer still gets $5 a year but has paid less for it, so their yield is higher. If the price rises, the yield falls.
Bond prices move with expectations about interest rates and inflation. If investors expect rates to rise, older bonds with lower fixed payments become less attractive, so their prices fall and yields rise. If investors expect rates to fall or the economy to weaken, they often buy bonds, pushing prices up and yields down.
The 10-year government bond yield is one of the most watched numbers in finance. It reflects what investors expect for interest rates and inflation over the next decade, and it feeds into borrowing costs throughout the economy, including fixed-rate mortgages and business loans.
Yields matter for sharemarkets too. When bond yields rise, safe bonds offer better returns, which can make shares look less attractive, particularly fast-growing technology companies whose profits lie further in the future.
Economists also watch the “yield curve”, which compares short-term and long-term yields. When short-term yields are higher than long-term ones, known as an inverted yield curve, it has often been seen as a warning sign of a slowdown, though it’s not a perfect predictor.
