Primary Market: When countries issue new bonds they are effectively borrowing from investors, in what is known as the primary market. Buyers of newly issued bonds lend capital to governments in exchange for a fixed payment, referred to as the coupon, up to a specific date referred to as the maturity date.
Coupon, Par, Yield: For example, in February 2014, Germany issued a new bond maturing in August 2046 and with a coupon payment of 2.5% which sold an average price of €99.40, a discount to par of €100 (“par value” is also known as “face value” or “principal”, the amount the bondholder will get back at maturity). This would imply a yield of 2.53% for an investor who purchased the bond at €99.40 and held to maturity, assuming reinvestment of the coupons at the prevailing interest rate.
Inverse Relationship: Bond prices and bond yields have an inverse relationship. When bond prices increase, bond yields decline since the payments are fixed (coupons + par value). In the above example, the annual coupon remains fixed at 2.50%, i.e. €2.50 per €100 par value. Bond prices have risen dramatically, pushing yields to record low levels, and generating huge returns for bond investors in recent years.
Secondary Market: Once issued in February 2014, these German bonds then began to trade in what is known as the secondary bond market, where investors can buy and sell on a daily basis, with prices impacted by many different factors. On Thursday April 30th 2015, the 2046 German government bond mentioned closed at a price of €144.69, with a yield of 0.86%, meaning those investors who initially bought at €99.40 saw a capital appreciation of 45.6%.
Investor Access: Investors can purchase individual government bonds within their brokerage account. More typically, investors will gain exposure to government bonds via passive or active bond funds, with greater diversification across a range of countries. An active manager seeks to outperform a specific benchmark while a passive manager seeks to replicate the performance of the benchmark.
Passive Bond Fund: For example, Irish Life Investment Managers offer a Passive AAA/AA > 10 Year Bond Fund which tracks the performance of the Merrill Lynch EMU Government > 10 Year AAA/AA Bond Index. This consists of long-dated government bonds from France, Germany, Belgium, Netherlands, Austria and Finland, sovereign states with a minimum credit rating of AA. (Long Term Bonds are typically considered to be those with a maturity of 10 + years)
Duration: The current yield of the ML EMU AAA/AA > 10 Year Index is 0.87%. The index has a duration of 15.07. Duration measures the sensitivity of bond prices to a change in yield whereby the longer the duration the more sensitive bonds are to fluctuations in yields; as a simple example, for every 1% change in yield there is an approximate 15% change in the price of the index. Therefore, if yields rise 1%, this fund could fall 15%.
Secondary Market Prices: Like any market, demand and supply will impact the price of bonds quoted in the secondary market, as well as a plethora of other factors, including investor sentiment which can change on a daily basis.
Decomposing Long Term AAA Bond Yields: However, when you look at AAA long term bond yields (AAA governemnt bonds are considered to have the lowest risk in terms of the possibility of default) there are three fundamental components, which central banks and market practitioners generally accept, when decomposing the yield. For example, if you take the German 30-year government bond, the yield can be decomposed into:
Implied by Current Long Term Bond Yields: The current yield of the German 30-year governemnt bond is circa 0.87%. Therefore, Long term European government bond yields are currently implying:
If the market is wrong and the ECB manages to reflate the economy, requiring the ECB to raise interest rates, bonds could fall sharply in value with yields moving higher.
Investors should be warned that while historical returns have been extraordinary, the outlook for returns is much more challenging. Even if interest rates remain low, returns will be relatively muted. In particular, long dated government bonds are most exposed to a rise in interest rates and so at current record low yields they are really only suitable for investors who want to match the future cost of purchasing an annuity at retirement.