What drives the yield of government bonds? 

Due to the current weak economic circumstances that we are experiencing here in Cyprus (as well as other countries in Europe), we are constantly bombarded with various economic and financial terms from the media, most of them unknown to the general public. One of them is the yield on the government bonds (of Cyprus, as well as other nations around the world). From the numerous times that we hear this term, one can understand that it is very important and can affect substantially our economy’s path, but does the average person (and not a sophisticated investor) know exactly what this means, or how is decomposed, or what drives its fluctuations? The purpose of this short article is to explain in simple terms the above relevant questions.

Definition

The yield (or return) to maturity is the average annualized rate of return of holding the bond until maturity, provided that the issuer (government in this case) does not default (misses an interest payment, or restructures its debt). This return is an outcome of the periodic coupon payments (usually every six months), the capital gain (or loss) when the bond matures or is sold, and the interest income that is generated from the reinvestment of cash flows. One can think of this return as a summation of the real risk-free rate (i.e. the rate of return on a risk-free security, excluding the impact of inflation), an inflation premium (i.e. a rate of return that accounts for the expected inflation in the economy), as well as risk premiums from other sources of risk (mainly credit and liquidity risk). The real risk-free rate and the inflation premium together constitute the nominal risk-free rate of return. If we compare the yields on Eurozone government bonds one can observe that the differences in terms of credit and liquidity risk among various countries leads to different levels of prices and yields (the higher the risk, the higher the yield). One should also understand that there is an inverse relationship between prices and yields (i.e. the higher the yield, the lower the price that the bond is traded).

Drivers of yield

Yields, as we are often reminded by the media, do not stay constant but are time-varying. Why is that? First, as the bond moves towards maturity, its price moves closer to the principal amount and therefore the yield will accordingly change. A second reason is a change in the credit quality of the issuer by the credit rating agencies, while a third is a change in the yield on comparable bonds (i.e. of the same credit quality). To highlight the second reason, when the credit quality of the Cyprus government was deteriorating prior to the March 2013 events, we had subsequent and multiple downgrades by the rating agencies which increased the yields to levels that were prohibitively high to borrow. I should note here that yields can also change because of changes in risk level, without any action by the rating agencies.

Furthermore, if you look at what is happening now across Eurozone and yields on comparable bonds, they have been going down mainly because of the extremely low base interest rates applied by the European Central Bank (ECB) as well as the Quantitative Easing (QE) programme of Mario Draghi that began last March. The QE programme increases the money supply in the European economy and thus the demand for financial (or other) products (increasing their price, and lowering their yield). It also has the added effect of sending positive signals to the market that the ECB stands ready to do whatever it takes to preserve the stability of the common currency and assist in bringing back growth to the problematic Eurozone economy.

As I pointed out above, changes in yield levels shape and affect the economic prospect of whole nations, thus they are very important. The aim of course from the perspective of the issuer is for them to be as low as possible so that they lower the cost of funding. One effective way of doing that is through fiscal consolidation and the necessary reforms to modernize the economy and make it more competitive.

The writer is an Associate Professor of Finance at Cyprus International Institute of Management (CIIM) and the Director of the MSc in Financial Services.

By Dr. George Theocharides

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