What is Bond Yields ? Why are they so important ?

What is bond yields
What is bond yields

Few things in the economy are more closely watched than bond yields. Weather you are into stock market investment , Waiting for your 401k returns or Real estate investor it effects every one. in this article we will deep dive into few frequently asked questions , What is bond yields? why are they so important ? how it works ?

– There are forces in play that merit watching. Some commodity prices and 10-year treasury yields have climbed. –

That’s the president of The Federal Reserve of Atlanta last March speaking about how The Fed gauges inflation and why it’s keeping a close eye on certain bond yields.

US government bond yields are a barometer for the economy, but they’re also more than that.

– US government bond yields are extremely important to the US and even in the global economy. Bond yields affect everything from the cost of a mortgage to the cost of borrowing for businesses. If you’re borrowing money, that’s gonna be determined to a large extent by US government bond yields. –

And changes in yields can impact you. Here’s how bond yields work and why they’re so crucial to the economy.

How Bonds work ?

When we talk about a bond yield, we’re typically talking about the annualized return an investor earns by holding a bond until its maturity date. Let’s break this down. A bond is a contract with features that are set from the start.

There’s the maturity date, which refers to the length of the bond’s life. This is generally two to 30 years. Bonds that mature between two and 10 years are also called notes.

Then there’s it’s face value, which is the amount the bond is worth when it’s first created and the amount it is guaranteed to pay on the maturity date.

There’s also the annual interest rate, otherwise known as the coupon rate. This is the fixed amount a bond pays each year up to its maturity date.

So say an investor buys a new 10-year treasury note with a face value of $1,000 and a coupon or yield of 4%. Every year, the investor will receive $40 and on the 10th year, she’ll get back the original $1,000 she paid for the bond.

Graphic diagram showing How Bond yields are paid and how bonds works?
How Bonds works ?

But here’s the thing, as soon as she buys that bond, she can sell it to other investors and when she does certain features of the bond are subject to change. If the economy is doing well, interest rates may go up, which means new bonds will be issued at a higher yield, bringing down the value of existing bonds. Say a new batch of 10 year treasuries pay a yield of 5%. Suddenly this bond is less attractive to investors and the price has dropped. When the price goes down, the yield goes up and when interest rates go down, this same dynamic happens in reverse.

Why Investors care about Bond yields?

The inverse relationship between the price of a bond and it’s yield is key to understanding why investors care so much about bond yields and why you sometimes see yields and stocks both going up at the same time.

Here is an important statement from sam Goldfarb, He covers changes in bond yields and how they’re connected to financial markets and the economy.

 Investors generally like bonds because they are a safe investment. The problem is that that return is gonna be often lower, much lower than stocks.

If investors are confident about the economy, they might not be satisfied with the small return they can get from US government bonds. They might choose to buy stocks instead.

But climbing treasury yields also signal that borrowing is getting more expensive. It’s basically a proxy for longer-term interest rates. If you want to get a rough sense of, you know, where your mortgage rates are gonna be going, you might look at the 10-year treasury note and it’s yield.

Bond yields aren’t just watched by economists and investors. The Federal reserve keeps a close eye on them as well. And they’re not just watching. Bond yields are a key part of monetary policy that The Fed uses to help influence the economy.

There has been an underlying sense of an improved economic outlook, and that has to be part of why rates would move back up from the extraordinarily low levels they were at.

jerome powell , US Fed chairman

That’s the chairman of The Federal reserve in March, 2021, talking about the rise in bond yields during the economic crisis.

In 2020, The Fed had slashed short-term interest rates at controls to zero in an effort to bolster the economy and encourage spending. And bond yields, which are heavily influenced by the outlook of short-term interest rates also fell to record lows. Two years later, much of the economy has rebounded.

Chart showing Bond yields during 2018-2021 period
Bond yield chart during 2020-2021 Pandemic

Last December inflation rose 7% from a year earlier. The fastest pace since 1982. This reflected rapidly rising prices on everything from houses to groceries. And when The Fed wants to restrain an overheated economy, it raises short-term interest rates. And when interest rates rise, bond yields go up as well. –

 If inflation is uncomfortably high, people don’t like that. The Fed has a goal of keeping prices stable and so it’ll try to cool the economy by raising borrowing costs. –

Higher interest rates can send up the price of mortgages and other loans, which will likely slow down consumer spending. This sounds like a bad thing, but only to a point. Higher bond yields can help cool down the economy, which should bring down inflation in the longterm.

chart showing US consumer price index ( CPI ) forecast to control inflation
US Consumer Price index after the Pandemic

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