Question

discuss at least four factors affecting bond yield

Answer 1

Factors affecting bond yield

1) Credit quality of bond: Yield of bond is highly dependent on credit quality of bond and issuer. Bond yields increase as credit quality of bond deteriorates. This is because perceived risk associated with bond cash flow repayments increases and investors demand higher return for investing in bonds. That is why government bond such as US treasury bond have lowest yields.This is because of high degree of confidence investors have in their capability to make interest and principal payments on time. AAA rated bonds are considered highly rated and have low yield. On the other hand, Non investment grade bonds or junk bonds are low rated and have high yields.

2) Inflation: Increase in inflation results in increase in bond yields.Bond yields change as the predictions about the expected inflation changes.This is because inflation decreases the value of money. bond investors demand higher yield to compensate for effects of inflation. If the expectation about future are that inflation will decrease or there will be deflationary environment in the economy then bond yields will decrease.

3) Time to Maturity. Yields of bonds in general increase as time to maturity of bond increases. This is because of maturity premium associated with longer duration of bonds. Investors demand higher yield for holding on to bonds for longer duration. Yields increase as investors are uncertainty about future repayments with the increase in bond tenure. This is referred to as upward sloping yield curve. On the other hand yield curve is downward sloping in periods of recession.

4) Market interest rates. As rates are reduced by central banks, yield of new future bonds decrease. This because central can now lend at lower rates to financial institutions. This results in decrease of lending rates in the financial market and also decrease in yields of bonds.

5) Private sector saving:Bond yields tend to increase as private sector savings decreases. As private sector savings decrease, supply of bonds tend to increase. This is because issuers are in need of money and they offer higher yields for their bonds. In periods of high savings, demand for bonds is high and yields are reduced.