Bonds, rising yields and global sell offs explained

Recent headlines have been highlighting global bond sell offs.

So, what is happening around the world?

Since the Middle East conflict and surging oil prices, global interest rates are rising to curb inflation.

Higher interest rates can cause bond selloffs as bond prices go down when interest rates go up.

New bonds pay more, so when interest rates rise new bonds are issued with higher payouts.

As a result, older existing bonds with older interest payments become less appealing to investors.

Sellers need to drop their prices to attract investors to buy older bonds thus creating a bond sell-off.

And as bond prices and yields are inversely related, when prices drop the yield or the expected return goes up to match market rates.

The bond sell off has raised the cost for governments to borrow.

It has also left them with higher interest bills that drain money from social and defence funds, as well as other programmes.

Public borrowing has increased following covid shutdowns, higher energy prices after Russia’s invasion of Ukraine and the US war with Iran, and higher defence spending.

With this in mind, small interest rate changes globally can have a big impact on government budgets.

The Head of Global Equities at Davy Aidan Donnelly has been working in this area for 31 years.

When it comes to bond yields “shooting up” he describes it as being relative to your starting point.

“Bond yields in the US were a hell of a lot higher than 5% when I started in this business, so it always comes from the prism of where you start.

“If you started in the bond market five years ago, you might think the bond yields have shot up and are so high, but if you started managing money or looking at equity markets and bond markets back in the mid ’90s, this doesn’t look particularly high.

“And if you go back into the ‘80s, you were looking at Irish government bonds in the 18 and 20% bond yield type space, so it just comes down to what your starting point is with all of these things.”

What is a bond?

A bond is quite simply a loan. It’s like a large, legally binding IOU, I owe you.

It allows governments and companies to borrow from investors rather than a bank.

So, for example a government issues a bond when it wants to borrow from investors.

They sell the investor a fixed-income debt security.

The issuer, the government, agrees to pay regular interest payments which are known as coupons.

The coupon rate is paid to the lender, the bond investor, in return for lending the money.

Then the issuer repays the original loan amount at a set future date when the loan matures.

The maturity date is the agreed-upon date on which the bond must be refunded.

Bonds can last from one year maturity right up to 50 or 100 years, but government bonds typically tend to fall in the one year to 30-year range.

What is a bond yield?

A bond yield is the annual return an investor makes on a bond, which is the IOU or loan made to a government of company.

If inflation starts going up, the bond market looks at that and identifies that the real value of the coupon in the future is a lot less than it was.

What happens then is the yield goes up, and as the yield on a bond goes up, its price falls.

The mechanism is quite simple, if interest rates are going up, bond prices are coming down. That’s the simple mechanism.

Yields and prices have an inverse relationship, as one goes up the other goes down.

Why are bond yields rising?

Government bond yields have surged to multi-decade highs across the US, UK, Germany, and Japan.

Surging oil prices and other knock-on inflation, anything that reduces the real value of that coupon in the future is going to impact the price today.

Governments that are running budget deficits are also impacting bond yields.

They’re spending more than they’re taking in in revenue, so they must borrow money.

So, it’s not only just inflation that’s impacting bond yields, but also the budget deficits that governments are running in both Europe, US and UK and Japan.

There has also been a surge in bond sales to fund AI investments which is also pushing up bond yields due to supply and demand.

With a drive on a need for borrowing, lenders or bond investors can charge higher interest rates which in turn pushes up yields.

What about Ireland?

Ireland’s public finances are in a strong position.

According to Davy, the budget surplus is set to outperform official forecasts again this year.

But spending pressures are high, particularly due to energy cost uncertainty stemming from events in the Middle East and we can’t escape global inflation.

Bond yields have ticked upwards in Ireland, but not as much as in other areas.

Lending in Ireland is not based on what the government bond rate is, unlike the US.

It’s influenced by where the ECB is in the short term interest rate market.

As the country isn’t running a massive deficit, there’s not a lot of borrowing at much higher interest rates than they were around a year ago.

Some funding will need to be replaced as bonds mature but it’s marginal in terms of what the impact on consumers could be.

In the broader context of people’s wealth, regardless of who is managing their pension or other portfolios, there’s a chance there are some global bonds in that.

So,if yields are going up, the value of those bonds are going down and therefore it will may have some impact potentially on the value of their pension.

What’s happening in the US?

In the US, the borrower is the federal government, and the bonds are called treasuries.

This week we saw the US 10-year Treasury yield rise to its highest level in nearly 20 years – it hit 5.04%, the highest it’s been since 2007 – before falling back slightly to just under 5%.

But this is part of a relatively rapid increase in what is essentially the price the US government has to pay to borrow money, the yield was just under 4% at the end of February.

This higher yield now partly reflects the situation that US debt is now above $40 trillion, while the jump in the price of oil has also had a major impact on bond yields.

Lending in America is also indirectly linked to the US Treasury.

Lending rates such as mortgages and car loans track Treasury yields, and the 10-year Treasury yield sets the baseline for 30-year fixed mortgages.

This means that when Treasury yields rise, consumer borrowing costs increase.

That is a big headwind for the economy in that if lending rates are too high, because it dampens demand for home mortgages, and demand for all other things that are priced off Treasury yields.

Why is there a global bond sell off?

Bond yields have been rising around the world for most of this year and have recently surged.

Nervy investors have been dumping government bonds across big economies.

This in turn has been driving up the cost of borrowing, as surging oil prices amplified fears about rising inflation.

George Cole, head of European Rates Strategy for Goldman Sachs Research, says there is a range of factors behind the bond sell-off—from swelling fiscal deficits and borrowing tied to investment in artificial intelligence (AI) to resilient economic growth and an energy-price shock.

Goldman Sachs reports that everyone is borrowing from the same pool of savings: Governments raising money for deficits and defense spending are now competing with companies borrowing heavily to fund AI buildouts, Cole says. With more borrowers chasing the same pool of global savings, rates get pushed up almost mechanically, regardless of what any single government does.

Following this week’s interest rate increase by the Federal Reserve, the yield on the benchmark 10-year U.S. Treasury slipped.

However, the Fed warned more hikes may be needed in the coming months to control prices.

Uncertainty over ‌how high interest rates could ultimately rise is likely to keep stocks and bonds volatile in the weeks ahead.