What is Yield in a Bond and how do they affect Fixed Income

The investor can recover his investment in two ways:wait until maturity to recover its face value plus the interest collected or by selling the bond. Yield to maturity corresponds to the difference between what the investor pays at a given time and the total amount he will receive until the maturity date, expressed as a percentage. In the past, the 30-year Yield has declined in USA and Germany. In the USA, the yield in the 90’s ranged between 7.90% and 9.08%, but right now the same security has a yield to maturity of 0.8413%. In Germany, we saw a decrease in Yield in the same direction and intensity, with a yield between 7.68% and 9.12% in the 90’s to a yield to maturity at this time of -.574%, something that has never been thought 30 years ago! Not even corporate bonds seem to escape to this trend. According to the U.S. Department of the Treasury, 10-Year High-Quality Market (HQM) Corporate Bond Spot Rate (), reached 9.84% in October1990 to a current low of 2.08%.

Why the yield has been in decline since the 1980s in US?

The most important aspect to consider when we look at returns over the years is inflation. Inflation corresponds to the increase in the general level of prices for goods and services in a determined period. The higher the inflation the bigger the returns the investor will demand.

The great Inflation refers to the period between 1965 and 1982 in the US where inflation skyrocketed from 1% in 1964 to 12% in late 1974, it then decreased to 4.88% in November 1976 and peaked in March 1980 at 14.76%! This event was caused by one simple thing: Excessive growth in the money supply.

How did it happen?

After the World War II, in 1946, President Harry Truman enacted the Employment Act in which he declared that the government was responsible for achieving the minimum possible unemployment.

In 1958, William Phillips published an article called “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom”. Phillips describes that after careful analysis, he found an inverse relationship between unemployment and changes in wages in the United Kingdom. It is important to understand the concept of the Phillips curve since it influenced the policies taken: Low inflation corresponds to a high rate of unemployment and low unemployment corresponds to a high rate of inflation. At this time, it was believed in this trade-off between inflation and unemployment and that the Keynesian policy could control and manipulate the variables to obtain the intended results. This belief proved to be false in the long run, causing a complete lack of control in inflation as it would come to be discovered in the late 1960s since “Participants in product and labor markets will learn to expect inflation… and that, as a consequence of their rational, anticipatory behavior, the Phillips Curve will gradually shift upward ”(Edmund Phelps, 1967).

In 1944, the Bretton Woods Agreement was signed between United States, Canada, Western European countries, Australia, and Japan. This agreement meant that there was a fixed rate of exchange between currencies around the world and the US dollar, which was linked to gold. This brought several problems, namely the incompatibility between the objectives of each nation and this international monetary policy and the increase in demand for dollars as the reserve currency (which caused an excessive accumulation by foreign central banks that held more dollars than those that were convertible into gold thus breaking the conversion to gold that had been agreed by the Bretton Woods Agreement). In 1971 President Nixon stopped the conversion of dollars to gold while inflation began to show signs of uncontrolled increase.

Another event of this time was the energy crisis,which increased oil prices and caused a slowdown in economic growth in the United States. In 1973 after the emergency financial aid was approved for Israel due to a conflict, OPEC embarked on the United States and cut the volume of oil production, causing an increase of about 300% between October 1973 and January 1974. Between 1978 and 1979, the increase in global demand for oil and clashes in the Middle East that caused a 7% decrease in world oil production, the price of a barrel doubled. The central bank believed that this brutal increase in the cost of energy was causing inflation and since Phillips curve indicated that high inflation is associated with low unemployment, the central bank chose to adopt expansionary policies that led to higher prices without any reduction in the level of unemployment. It is believed that the data was being misinterpreted as they underestimated the effects of their policies on inflation and overestimated the effects on unemployment.

Central banks

Bond prices on the markets react inversely to the behavior of changes in interest rates. If interest rates decrease, there will be a greater demand for bonds that have already been issued, as they offer greater profitability. By increasing the demand for bonds, their price will also increase, leading to a decrease in yield to maturity because for the same return we will now have to pay a higher price for the asset. Thus, Central banks influence the price of assets through monetary policy. By decreasing the yield, it makes it less expensive for companies and governments to finance themselves, thereby promoting increases in aggregate consumption.Another way for central banks to influence yield is through Quantitative Easing. QE consists of buying bonds or other financial assets so that they can inject money into the economy. However, QE is not an easy task to accomplish because if it is poorly planned or executed. The increase in money supply will certainly bring inflation. The most relevant example of QE in recent years was in 2008 when the FED started buying mortgage-backed securities and treasury bills to provide liquidity to banks when the scenario was very negative.

In a nutshell, bonds yields change according to several factors such as inflation and interest rates. To understand the real profitability that a bond may have, it is a good idea to look at the current and expected inflation in the future because it decreases the real value of the bond’s profit. It is also necessary to pay attention to the monetary policy of central banks, since these can directly affect the yield of bonds, through the change in money supply by way of changes in interest rates (influencing the level of inflation as seen previously or) or open market operations (through the purchase and sale of securities that causes changes in bond prices and consequently changes in yield).

This article is in our October Newsletter

Tomás Reis

Published by lisboninvestmentsociety


Leave a Reply