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Friday, 23 March 2012

Why Are Bond Yields So Low - Part 2



Why are Bond Yields So Low – Part 2

For those that read last week's post on bonds regarding why bond yields are at current low levels, this week's post should provide you with the answer. The background was that 10 year Treasury Notes are currently yielding around 2.3%, down from 5% pre GFC, and some think that there's still a possibility of re-testing lows at 1.67%. The bond yield is made up of two main components, the default risk of the bond issuer and future risk free rate expectations, and these broken down below.
 
The risk free rate - usually the rate that the central bank will lend to you at - represents a yield that you should be guaranteed to receive over its maturity. You would demand a higher yield for anything that wasn't risk free, in order to compensate you for the probability that the other party may default on its obligations to pay you. The US government may be highly unlikely to default, but the yield on government bonds is still higher than the central bank's rate due to this small probability. This theory explains why Greek bonds and notes have had some of the highest yields on the world - their country is perceived to be most likely to default on its debt, leading to investors to demand a higher yield before they will buy the bonds.

Factors in the Bond Yield

Due to this risk, government bonds will often trade a certain % above the risk free rate, say 1%. The current risk free rate in the US is close to 0, so investors should be compensated with an extra 1% today. But what about the extra 1.3% that brings you to today's bond yield of 2.3%? The government is lending to you for 10 years, so it's only fair that if the risk free rate increases in future, you are compensated with a higher bond yield. But if you lock in the price of your bonds today, you also lock in the yield. In order to remove this problem, the bond yield today is a reflection of what the risk free rate is expected to be from now until when the bond matures. That way you shouldn't lose out in future, unless yields rise much higher than you thought. This part accounts for the remaining 1.3% (or most of it), bringing you to today's yield of 2.3%.

If the risk free rate is suddenly expected to rise in future  years, bond yields will also rise to reflect this, causing the price of bonds to fall (remember from last week that prices and yields move in opposite directions). This is what, essentially, forms the basis of speculation in the bond market.

In the pipeline: how to build a trading model - part 1

Bullish on: Banking stocks (Bank of America (US), ANZ (Aus) - dividends increasing, people rotating into the sector to escape the selloff in mining stocks)

Bearish on: Mining stocks (whether you believe it or not, the supposed end of commodity price inflation will hurt mining stocks like BHP and Rio Tinto)

As always please feel free to leave any comments or questions that you may have. If you are looking for more


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