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HomeMoneyHow do bond markets work? We explain how language affects YOUR savings,...

How do bond markets work? We explain how language affects YOUR savings, pension, and investments.

Global government bond markets are huge and impact everyone who pays taxes, saves for retirement, or makes long-term investments.

Despite our best efforts to clarify the jargon used by industry insiders to This is Money readers, it is frequently difficult to understand what is happening when there is a rise in bond buying or a sell-off.

How do bond markets work? We explain how language affects your savings, pension, and investments.
How do bond markets work? We explain how language affects your savings, pension, and investments.

To make it easier to comprehend why the UK Government is suddenly paying more or less interest on its loans on our behalf and what that would mean for the regular investors and large institutions lending it money, we have decoded a few important terminologies below.

Financial market participants regularly monitor bond market activity as a leading indicator of the domestic and international economic outlook.

This is not a foolproof method for predicting economic expansion or contraction – nothing is – but we explain how it is done below.

What are municipal bonds?

Governments throughout the world issue bonds to borrow funds for bill payments. Individuals and institutions, including banks, insurers, and pension funds, purchase them to gain a profit.

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How do bond markets work? We explain how language affects your savings, pension, and investments.

Instead of merely referring to them as “UK government bonds,” “US government bonds,” etc., they are frequently referred to by nicknames or acronyms.

It suffices to know that when individuals discuss gilts, they are referring to our government’s debt. US bonds are known as treasuries, while German, French, and Japanese bonds are known as bunds, OATs, and JGBs, respectively.

Governments issue bonds with a variety of maturities, including three months, one year, ten years, thirty years, etc. This is the amount of time that governments give themselves to repay investors.

Short-term bonds are those that mature quickly and are, as a result, considered less hazardous in typical circumstances. Long-term bonds are considered riskier since there is more time for things to go wrong, thus investors must wait longer to receive their money.

Bonds with a ten-year maturity are the most talked about and observed by financial experts and non-industry members with an interest.

While bonds are maturing, governments pay investors interest, known as the coupon. In the end, they pay back everything, if they don’t default, which practically renders them bankrupt. Bonds are purchased and sold on the enormous worldwide market for sovereign debt in the meantime.

What are bond yields and prices?

Bond prices represent the cost of bonds, or the amount that investors pay to acquire the debt.

Bond yields represent the annual return on government debt for investors. The yield is the coupon or interest rate you receive for holding bonds.

Yields and bond prices move in opposite directions. As prices increase, yields decrease, and vice versa.

Their movement is largely determined by the level of demand for bonds on the market at the moment. When there is a significant demand for bonds, for instance, because they are viewed as a haven, their prices increase and governments can pay less interest on their debt due to lower yields.

When there is a bond sell-off, as a result of investors’ belief that they can obtain a greater return from equities, for instance, bond prices decline and governments end up paying higher interest rates to attract investors via a higher yield.

There is a rule of thumb that yields become unsustainable when they reach approximately 7 percent because at that time governments must pay so much interest to service their loans that they will never be able to pay everything back.

Greece’s bond yields surged well above 7% a few years ago, which is why Athens, eurozone leaders, the IMF, and bondholders have been embroiled in a nasty dispute over its debts ever since.

During the apex of the eurozone crisis, Spain and Italy’s yields briefly approached or above 7%, but only momentarily, as the prospect that they might follow Greece subsided.

Nevertheless, the Italian referendum on Sunday could spark a fresh euro crisis, and if that occurs, Italian and Spanish bond yields will likely surge once more.

What has happened to bonds during the past few decades?

Government bonds are viewed as a more secure investment compared to equities and corporate bonds, which refer to corporation debt, and are kept as a form of diversification in many portfolios and pension funds.

After the 2008 financial crisis, there was a flight to safety on the part of investors, which explains the high demand for bonds.

In an era of historically low-interest rates, they offer a better yield than savings and are viewed as less volatile than stocks.

After the financial crisis, central banks began to make large purchases with newly-printed money as part of their quantitative easing initiatives to assist and revive faltering economies, which led to an increase in demand for bonds.

As a result, rates have plummeted to record lows, and many financial experts believe a bond bubble has burst.

They have long worried about a bond meltdown whenever central banks begin to boost interest rates again because investors could conclude they overbought government and corporate bonds and sell them quickly.

The idea that a Donald Trump presidency in the United States will trigger a bout of inflation sparked a gradual sell-off that has recently escalated.

Fears of inflation make investors reluctant to invest in bonds with interest rates that may lag behind inflation over the long term.

This has resulted in financial losses for existing bondholders as their prices decline, whilst new buyers are now receiving higher returns.

What can changes in the bond market tell us about the future?

Government bond markets are closely monitored by financial professionals because they serve to explain investor attitudes toward current events and hazards. They may even be able to predict the future, such as an economic boom or a recession.

Bond watchers accomplish this using a crucial and revealing indicator known as the yield curve, so it’s necessary to understand how this works and decipher the complicated terminology around it.

What exactly is a yield curve?

In its simplest form, this demonstrates the yield on bonds of various maturities at a single point in time.

This week’s yields on gilts with varying maturities are depicted in the yield curve shown below.

Bonds with shorter maturities will typically have a lower yield or interest rate because investors perceive them to be less risky and are therefore willing to accept a lower return.

However, the yield on bonds with longer maturities, such as 10 years, tends to be higher because there is a greater probability of something going wrong, thus investors view them as riskier and desire a higher return.

The current scenario is evident from this graph.

This yield curve by itself is of little interest. People are interested in its evolution over time.

To analyze the yield curve, one might examine the difference between yields on bonds with different maturities, such as two- and 10-year bonds.

Examining the extent of the gap between these two yields, as well as whether it is growing or narrowing over time, allows one to measure investors’ perceptions of future risk levels.

The yield curve for the UK is displayed in the graph below. It demonstrates how the yield spread between two-year and ten-year bonds has narrowed and widened over the past year.

What occurs when the yield curve steepens, levels off, or inverts?

Currently, the margin is widening and reached approximately 1.30 percent this week. The two-year bond of the United Kingdom yields 0.12%, while the ten-year bond yields 1.42 %.

When the gap widens and the yield curve line rises as a result, experts refer to this as steepening.

It reached its lowest point of the year on August 12, at 0.46 percent. At that time, the yield on the two-year bond was 0.14 percent and the yield on the 10-year bond was 0.60 percent.

When the gap is closing and the yield curve line is falling, financial professionals refer to this as the yield curve flattening. This phrase is deceptive since it portrays a level line, whereas the line is descending.

Historically, the yield on 10-year bonds has occasionally fallen below the yield on 2-year bonds. This essentially indicates that investors are demanding greater interest rates on short-term government bonds than on long-term government bonds.

When this occurs, experts refer to it as an inversion of the yield curve. This shows that investors are extremely concerned about the near and long-term economic outlook, so they are flocking to bonds as a haven, causing bond prices to rise and yields to fall across the board.

Since 1996, these occurrences are depicted in the two graphs below for the UK and US yield curves. The yield curve inverted, with 10-year yields falling below 2-year yields, before the 2000-2002 and 2007-2009 recessions.

During the recoveries of 2003-2005 and 2009-2011, the curve steepened but subsequently flattened as economic growth proved disappointing.

What does the yield curve’s shape reveal?

According to AJ Bell investment director Russ Mould, a steepening yield curve reflects investor optimism in the economy, a flattening yield curve communicates skepticism, and an inverted yield curve denotes pessimism.

As long-term interest rates rise, any steepening of the yield curve indicates that the market is pricing in higher inflation and/or a tightening of monetary policy in the form of higher interest rates. This is indicative of robust economic growth in the future,’ he explains.

‘The yield curve may also steepen if short-term interest rates decline while long-term interest rates remain steady. This is what central banks have been attempting to accomplish with quantitative easing initiatives, as it increases the profitability of banks — they borrow at the lower rate and lend at the higher rate, pocketing the difference as profit.

As short-term interest rates are being artificially suppressed, some say that this manipulation of the yield curve renders it less useful as an indicator.

‘The yield curve may also flatten if short-term rates rise while long-term rates remain steady, or if the yield on 10-year bonds falls more rapidly than that on 2-year paper.

This typically reflects market dissatisfaction with growth and anticipation that interest rates would fall as central banks attempt to stimulate economic activity.

When the yield on 10-year bonds falls below that of 2-year bonds, the yield curve is said to be inverted, and this is typically viewed as a precursor of recession.

For the time being, the yield curve in the United Kingdom is steepening as markets anticipate President-elect Donald Trump’s plans to revive flagging U.S. – and, by extension, global – growth through corporate tax cuts and infrastructure spending, as well as Prime Minister Theresa May’s similar policies.

Jason Hollands, managing director of Tilney Bestinvest, asserts that QE has resulted in flatter curves, which have constrained bank profitability since 2008, a period in which banks faced a variety of other constraints.

He explains why bank shares have risen since August when curves began steepening.

Hollands adds, “In the early 1990s, the savings and loan business in the United States was practically bankrupt; it was a miniature version of the current banking crisis.”

Alan Greenspan, then-chairman of the Federal Reserve, “fabricated” a steeper yield curve to assist savings and loan institutions in earning their way out of financial difficulties. This was a very elegant and effective solution to the issue.

Mould states, “There is no such thing as an infallible indicator.” During 2013-2015, the yield curve flattened significantly, but there was no recession, only lackluster growth.

Many financial experts, according to Mould, believe that central bank quantitative easing operations, which include the purchase of vast volumes of bonds, have rendered the yield curve less dependable. A ‘false, price-insensitive buyer’ has recently entered the market.

Hollands states, ‘Changes in the yield curve reveal how market expectations regarding inflation and interest rates are shifting over time.

‘A steepening yield curve can be a sign of both rising economic confidence and inflationary fears, so it is important to examine what is driving price changes.

‘Currently, the yield curve is steepening because Donald Trump’s policies are projected to increase global inflation, the cost of imports into the UK is rising due to the weak pound, and the price of oil has soared this week due to an agreement with oil producers to limit production.

In recent years, however, central banks have taken direct action to shape the yield curve by producing new money and using it to purchase bonds on the market to affect yields and keep them low.

‘For instance, the Bank of Japan has purchased almost 40% of the Japanese government bond market to keep borrowing prices below zero. In this scenario, the yield curve reflects not only investor projections but also attempts to predict what central bankers would do next.

If the markets see an end to direct interventions in the bond markets, yields might climb considerably.

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