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Government Bond Yields & Their Influence on the Valuation of Other Asset Classes

There are two fundamental principles that should be understood about government bonds;

  1. They offer a fixed rate of interest over a set period of time and the guarantee of your capital back at the end of that period
  2. The rate of return on a long term government bond (say a 10-year bond) is referred to as the 'Risk Free' rate of return. Other assets offer attractive or unattractive returns relative to the risk free rate.

A Fixed Rate of Interest
If the German Government issues a 2020 Bond at €100 with a coupon of €3.3 paid annually with capital back in April 2020, then it will have issued a 10-year bond with an yield of 3.3%. Investors who buy this bond get paid 3.3% annual interest and their €100 of capital is repaid in 10 years. The German Government can normally only issue the bond with a coupon of 3.3% if investors are prepared to buy the bonds with that level of coupon attached. Investors, in aggregate, set the level of long term interest rates through their buying and selling in the market place. If there are more sellers than buyers then the yield may drift upwards until buyers emerge, but that might only be when 10-year interest rates are at 4%. So how, in practice, does that happen.

Next is an explanation of falling bond prices in response to rising long term interest rates and how that squares with €100 or par value being paid back at redemption.

Let's say long term interest rates on Irish government 10-year bonds (debt) rises to 6% from 4.53% currently. Under this scenario, the price of the 10-year government bond will decline to offer the new investor the equivalent of a 6% per annum return over the remaining life of the bond. If the coupon on the bond was initially 4% when it was issued at the original par price of €100 then the new investor must be offered an additional 2% per annum over the remaining life of the bond. If the remaining life is 10 years, then the bond price may fall to €87. The annual coupon paid is now 4.5% (4/87 = 4.5%) and the capital gain to redemption is €13 or 15% (13/87 = 15%) or 1.5% per annum. In this way, the new investor gets his/her 6% annual return via a 4.5% annual coupon and a 1.5% annual capital gain payable in one sum at redemption. So when bond investors talk about a 10-year government bond yielding 4.53%, what they actually mean is that the 10-year bond offers a 4.53% yield to redemption. This redemption yield is part annual interest and part capital gain/loss at redemption.

In practice, then, rising bond yields reflect falling bond prices and declining bond yields reflect rising bond prices.

US Bond Yield 1980-2009

The chart opposite shows the US 10-Year Government Bond yield from 1980. What you see if a continuous, albeit, on occasions, interrupted, decline in US bonds yields. Said another way, US long term market-determined interest rates declined continuosly from circa 1982 onwards. At any point in time, the bond market reflects what investors, in aggregate, believe interest rates will average over the next 10 years. So for nearly 30-years, bonds yields were declining which means bond prices were rising. Now that is one hell of a bull market.

Subscribers should not confuse market-dertermined long term interest rates with short term central bank contrlled interest rates. Currently, European overnight interest rates have been set at 1%. This is not a market rate, it is the European Central bank rate. Hence, Central banks can and do determine short term interest rates.

The market sets long term interest rates and the markets view of where long term interest rates are going changes by the day just like equity market gyrate on a daily basis.

Central banks can influence long term interest rates if they enter the bond market as buyers. Their demand, if large enough, will force prices up and yields dowm. If the central bank buys bonds in this way with money it creates itself, then this is referred to as money printing or quantitative easing. In the current global banking crisis, Central Banks in many countries did enter the bond makets to buy bonds, shove up prices and yields down. As Central Banks can print their own money, they have potentially unlimited buying power. In this way, they can manipulate long term interest rates down. This is very powerful as it detremines the rate at which we pay for long term borrowings, and in this crisis has significantly eased the burden for everyone. For every bond nbuyer, there is a seller. With quantitative easing, the sellers get a good price and they can recycle the money into other assets and in time into projects in the real economy fueling a self-sustaining economic recovery.

Savvy investors understand this process well and it kick started the global equity market recovery in March 2009, as enough investors at that time believed that the massive central bank bond buying would fuel a recovery in other asset classes and then the economy. So far, markets have read it right and read it early - and that is why they say that the stockmarket anticipates recovery in the real economy often some 12-18 months before recovery could through. It is why so many private investors are baffled when markets recover in the midst of appalling news. It is not the news of the day that matters, it is what investors in aggregate, believe will happen in a years time that matters and that is the hardest thing of all to judge. And you will not judge it by reading what the media has to say. It can be best seen in charts, for charts record what investors, on average are doing, not what they are saying. The fact is that a fund manager can remain bearish and scared like the rest of us but if he is buying and not selling then prices will be rising and not falling. Fund managers in aggregate only have to make a modst shift from casn to equities to start a rally. The rally can turn fear into greed overninght and soon confidence returns. Obviously, the outbreak of optimism must eventually be backed up with recovery in the real economy but that is not important at the beginning.

A Bond as the 'Risk Free Rate of Return'
If long term interest rates are at 4% as dertermined by the market, then this is a guaranteed return and returns from other assets will be influenced by this. For example, say you were looking to buy an apartment as an investment for a price of €250,000 and the annual rent is €10,000 providing you with an annual income of 4% (let's ignore costs to keep it simple).

The rental yield of 4% is equal to the bond yield of 4% so you might not be fussy which you buy. My point is that the bond yield is influencing your maths, and quite rightly so. If the 10-year bond yield rose to 10% then as an investor you are faced with the choice of investing in that bond for a guaranteed annual return of 10% for 10 years on the trot. You might then think twice about that property with an initial rental yield of 4%, and quite righly so. The property you were looking at would have to decline in price to €100,000 to offer a competing 10% annual rental yield. In this way, the level of long term interest rates influences the prices of alternative assets. Of course, the rent on the property can grow with economic growth so there are others factors that determine the value of a 'real' asset (like equities or property) as opposed to a monetary asset (like a government bond). And you might recall from the 1-day seminar (if you have attended one) that there are two main influences on asset prices;

  1. The growth in rent (property) or corporate earnings (equities)
  2. The level of long term interest rates (bond yield) versus the rental yield (property) or the earnings yield (equities)

In summary, long term interest rates influence the value of other assets.

How Can a Private Investor Deal in Government Bonds
Most stockbrokers deal in government bonds. But buying in small size can be a problem as the market in bonds is dominated by institutional investors who transact in deal sizes OF €100,000 and above and mostly well above those levels. That said, private investors can deal in government bonds but with smaller deal sizes (i.e. below €100,000), you may have to be patient. But your broker should be in a position to tell you what is possible and what is not. I am unsure whether investors can deal in government bonds through online dealers. I suspect they can but I will find out from one of the Dublin-based online dealers and ODL in London and post a further answer. I have never bought a government bond myself, my glass has always been, naively, half full i.e. I have always assumed I can do better than a bond return. I'm more humble now!

Buying a Bond Fund is Not the Same as Buying a Single Bond
An ETF or other fund structures that provide exposure to government bonds are not the same as buying an individual government bond. In the case of an individual bond there is a redemption date and capital is returned intact on that date. With a bond fund, which may own many bonds each with different maturity dates, there is no such thing as a redemption date for the investor. Rather a bond fund offers a kind of guaranteed perpetual income stream but a capital loss is possible. The same is true of corporate bond funds.

Rory Gillen
2nd April 2010