What it means
The yield tells you the return you would receive for lending money to a government at today's price. It is not the same as the coupon, which is the fixed interest printed on the bond, because the yield also reflects whether you pay more or less than face value.
Prices and yields move in opposite directions. When investors rush to buy a bond, its price rises and the yield falls, and when they sell, the price falls and the yield rises.
A rising yield for a country usually signals that investors want more compensation. They might be worried about inflation, a larger budget deficit, political instability or the risk of default.
Businesses and households feel the effect directly. Mortgage rates, corporate loan rates and the discount rates used to value projects are often built from the government bond yield plus an extra margin for risk.
Yields are compared across countries and over time. The gap between one country's yield and a safer benchmark country's yield is called the spread, and it is a quick measure of how risky the market thinks the first country is.
The yield curve plots yields for bonds of different maturities. A normal curve slopes upward, while an inverted curve, where short-term yields exceed long-term yields, has often been watched as a warning about the economy, although it is not a reliable predictor on its own.
In practice
Real-world examples.
Example
A treasury manager at an exporter plans a five-year loan to build a new plant. She tracks the government bond yield each week because the bank will quote a rate equal to that yield plus a fixed margin, and she wants to fix the rate when it is low. If the yield rises before she signs, the project becomes more expensive.
Example
A fund manager compares two emerging market bonds, one yielding 6% and the other 9%. The higher yield looks attractive, but she checks whether the extra 3 percentage points is enough to cover the extra chance of default and currency losses. She decides to hold the lower-yielding bond for a safer core and a smaller amount of the higher-yielding one.
Example
A property developer sees government bond yields jump by one percentage point in a month. Because buyers' mortgage costs will rise, the developer lowers expected sale prices in the financial model and delays one launch. He explains to the board that the cause is the cost of borrowing, not weak demand for the homes.
Formula
Calculation
Sovereign spread = yield of the country's bond - yield of the benchmark bond
Real yield = nominal yield - inflation rate
A country issues a ten-year bond yielding 7.5% while the safe benchmark ten-year bond yields 4.0%. The spread is 7.5% - 4.0% = 3.5%, which is 350 basis points (one basis point is one hundredth of a percentage point). If inflation is running at 5.0%, the real yield is 7.5% - 5.0% = 2.5%, so after inflation the investor's buying power grows by about 2.5% a year. If inflation instead rose to 8.0%, the real yield would turn negative at -0.5%, meaning the investor's money would buy less each year despite earning interest.Case study
Seen in the real world.
Eldoria is an illustrative, fictional country whose ten-year bond yield was 4% when the economy was stable. After a political crisis, investors demanded more compensation, and the yield rose to 7% within six months. Local banks, which held many of the bonds, saw the value of their holdings drop at the same time.
On $10,000,000,000 of new borrowing each year, the extra three percentage points meant an additional $300,000,000 of interest annually. That money could otherwise have funded several new schools. The government had to choose between raising taxes, cutting spending or borrowing more.
The illustrative finance minister announced a credible plan with spending limits and independent oversight. The yield fell back to 5% over the following year, and the savings on interest of about 2% on the same debt amounted to $200,000,000 a year.
Watch out
Common mistakes.
- Confusing the yield with the coupon rate, when the yield changes with market price and the coupon stays fixed.
- Reading a higher yield as simply better, when it often signals that investors see higher risk and may be a sign of stress.
- Comparing yields across countries without allowing for inflation and currency differences.
Questions
People also ask.
Why do yields rise when bond prices fall?
Because the fixed coupon becomes a larger percentage of a lower price, so a buyer earns more per dollar invested. For example, a $40 coupon is 4% of a $1,000 price but 5% of an $800 price.
What is a basis point?
It is one hundredth of one percentage point, so a move from 4.00% to 4.25% is a rise of 25 basis points. Using basis points avoids confusion when talking about small changes in rates.
Why should a manager outside finance care about it?
Because it sets the base for borrowing costs across the economy, which affects loan rates, investment decisions and customer demand. A company that plans a large borrowing should watch the trend before it commits.
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