Yields on bonds of different maturities reveal much about an economy’s prospects

For centuries, governments have turned to investors to fund their activities. They mostly do this by issuing bonds. Today the global market in government sovereign debt is worth about $100 trillion—almost as large as the world economy itself. But what are government bonds? What determines how much investors will pay for them? And what can bond “yield curves” tell us about an economy?

Consider a government whose outlays exceed its revenues by $100. To finance the deficit, it can borrow from investors by issuing a bond. The bond is a promise by the government to pay back the $100 principal to investors at a future date, plus annual interest, called a coupon payment, to compensate investors for the opportunity cost of parking their funds in the bond rather than some other investment.

This opportunity cost has two components: an inflation component (to preserve the purchasing power of investors’ money) and a real, inflation-adjusted, component (the additional return, on top of inflation, investors might forgo on alternative investments). The higher the expected rate of inflation and returns on alternative investments, the higher the return the government must generally offer investors.

Suppose the government issues a one-year $100 bond, or bill, with a coupon rate of 5 percent. This is a commitment to pay back investors $105 after one year: $100 in principal, $5 in interest. If the coupon rate equals the investors’ opportunity cost, investors will be willing to buy the bond at its face value, or at par ($100, in this example).

But if investors’ opportunity cost exceeds the 5 percent coupon, they will buy the bond only at a price below par. Say they are willing to pay only $98. This would provide a higher return on their investment, specifically 7.1 percent [(105÷98)-1]. This total return, which by definition equals investors’ opportunity cost, represents the bond’s yield (or yield to maturity).

For centuries, governments have turned to investors to fund their activities. They mostly do this by issuing bonds. Today the global market in government sovereign debt is worth about $100 trillion—almost as large as the world economy itself. But what are government bonds? What determines how much investors will pay for them? And what can bond “yield curves” tell us about an economy?

Consider a government whose outlays exceed its revenues by $100. To finance the deficit, it can borrow from investors by issuing a bond. The bond is a promise by the government to pay back the $100 principal to investors at a future date, plus annual interest, called a coupon payment, to compensate investors for the opportunity cost of parking their funds in the bond rather than some other investment.

This opportunity cost has two components: an inflation component (to preserve the purchasing power of investors’ money) and a real, inflation-adjusted, component (the additional return, on top of inflation, investors might forgo on alternative investments). The higher the expected rate of inflation and returns on alternative investments, the higher the return the government must generally offer investors.

Suppose the government issues a one-year $100 bond, or bill, with a coupon rate of 5 percent. This is a commitment to pay back investors $105 after one year: $100 in principal, $5 in interest. If the coupon rate equals the investors’ opportunity cost, investors will be willing to buy the bond at its face value, or at par ($100, in this example).

But if investors’ opportunity cost exceeds the 5 percent coupon, they will buy the bond only at a price below par. Say they are willing to pay only $98. This would provide a higher return on their investment, specifically 7.1 percent [(105÷98)-1]. This total return, which by definition equals investors’ opportunity cost, represents the bond’s yield (or yield to maturity).

A direct bond sale by the government to investors is a primary market transaction. But bonds can also change hands between investors in the secondary market. This is because bonds are tradable securities, like stocks. The key implication is that the issuance yield on a bond can differ from the prevailing market yield.

For instance, let’s assume that a major commercial bank fails immediately after the government issues the $100 bond above. This fuels fears of a financial crisis and recession. As investors come to expect smaller returns and lower inflation because of the recession, the opportunity cost of funds falls sharply, from 7.1 percent to 3 percent. In this situation, the bond issued at $98 will now trade above par in the secondary market, at $101.95, to reflect the new market yield of 3 percent.

Governments can issue bonds of different maturities, typically ranging from 1 to 30 years. Each bond has its own coupon rate and associated yield to maturity. Longer-term bonds usually carry a higher yield. This is called term premium. It reflects the additional compensation investors demand for the uncertainty associated with future inflation and economic conditions, and for forgoing other investments for longer.

Chart 1 plots bonds’ maturities on the horizontal axis and their corresponding market yields at a given time on the vertical axis. These yield curves tell us many things—the most important is whether markets expect the economy to strengthen or weaken.

For centuries, governments have turned to investors to fund their activities. They mostly do this by issuing bonds. Today the global market in government sovereign debt is worth about $100 trillion—almost as large as the world economy itself. But what are government bonds? What determines how much investors will pay for them? And what can bond “yield curves” tell us about an economy? Consider a government whose outlays exceed its revenues by $100. To finance the deficit, it can borrow from investors by issuing a bond. The bond is a promise by the government to pay back the $100 principal to investors at a future date, plus annual interest, called a coupon payment, to compensate investors for the opportunity cost of parking their funds in the bond rather than some other investment.