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Why Are Bond Yields Not Higher?

Typically, economists will teach - if Government borrowing rises, if there is a rise in

debt to GDP ratios, then we would expect interest rates on government bonds to rise.

The logic is that:

y  To attract more investors to buy government debt, we need to raise bond

 yields.

y  R ising debt levels make markets nervous about the governments ability to

repay. Therefore, markets demand a higher interest rate to compensate the

increased risk.

This did happen in the case of Greece, where worries over debt sustainability led to a

rapid rise in bond yields (until EU and IMF intervened) It has also happened in

Ireland and Spain, with

However, in the case of the US and to an extent the UK, there has been a marked rise

in debt to GDP ratios, but bond yields have remained very low.

In the US, 10 year bond yields are currently 2.5%, down from just below 4% in 2008.

This is despite a rise in national debt as a % of GDP from 70% to 87% (May, 2010)

 Why?

1.  Investors want to buy government bonds because they are seen as a better

investment than private sector investment. In a recession / sluggish recovery,

there are few investment opportunities in the private sector. Banks are

reluctant to lend to private business. Mortgage deals are scarce. This me ans

 banks have surplus liquidity, they are choosing to buy government bonds.

2.  R ise in the Savings R atio. A typical event in a recession, is for the savings ratio

to rise. Consumers and firms are risk averse; therefore they save rather than

invest and spend. These savings may be deposited in banks - at very low 

interest rates or it may be used to buy government bonds at slightly higher, but still low interest rates.

3.  Market expectations that debt levels will be brought under control in the long

term. The rise in debt to GDP levels is seen as a temporary response to the

financial crisis and recession. Markets expect when the economy recovers

governments will be in a position to raise taxes, reduce spending and tackle

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the structural deficit. There is also an expectation that economic growth will

help reduce the debt to GDP ratios over time.

4.  If markets didn't expect the Debt to GDP ratios to fall in the long term, then

interest rates would be rising, as insolvency fears would be much greater.

 Another issue is the yields on Irish bonds. They have risen from 4.6% at the start of the year to 5.6% now. This is despite attempts to reduce budget deficit by cutting

spending. (Ireland and Spain yields)

Do Markets Adequately Price Bonds?  

Markets are far from perfect in anticipating correct price and interest rates on bond

 yields. Earlier in the year, the sharp rise in Greek bonds showed that previously 

markets had been underestimating the risk of Greek bonds. However, markets can

also over-react in the other direction. There can be a snowball effect as investors pull

out of a particular bond.

Currently many say we should be slashing government debt because markets will

soon be demanding higher interest rates on bond yields. However, in a recession - in

a liquidity trap - it is important to bear in mind, markets may have a surprising

appetite for government debt. The rules are different to what is prudent for a

government to borrow during a period of full employment.