Sovereign Bond Yields

A sovereign bond yield is the return implied by the market price of a bond issued by a national government and its promised payments. When investors perceive greater default risk, meaning a greater possibility of missed or reduced payments, they generally demand a higher yield to hold that bond.

Why greater default risk raises the required return

Investors buy government bonds expecting interest payments and repayment of principal. If the government appears less able or willing to honour these obligations, the promised payments become less secure.

• Investors demand a larger default-risk premium, which is additional compensation for bearing the possibility of non-payment or debt restructuring.
• At the existing price, the bond becomes less attractive relative to safer alternatives, so demand weakens and some existing holders sell.
• The yield spread over a comparable safer bond therefore tends to widen, provided other influences, such as maturity and liquidity, are comparable.

How a falling bond price produces a higher yield

For an existing fixed-rate bond, the coupon remains unchanged even when its market price falls. A buyer paying less for the same promised payments obtains a higher quoted yield: bond prices and yields move in opposite directions.

• Current yield equals the annual coupon payment divided by the current market price, so a lower price raises this measure directly.
• Yield to maturity also incorporates the promised principal repayment and the timing of payments; a lower purchase price raises it when promised cash flows remain unchanged.
• A higher quoted yield is not a guaranteed higher realised return: if default occurs, actual receipts may fall below the payments used to calculate that yield.

What this means for government borrowing

Higher secondary-market yields signal the return investors require on comparable new borrowing. The government may consequently have to offer more attractive terms when issuing new debt or refinancing maturing debt.

• Higher debt-servicing costs can put pressure on the budget and, other things equal, increase financing needs.
• A market-yield increase does not itself raise coupon payments on existing fixed-rate debt; the budgetary effect depends partly on refinancing needs and the debt structure.
• Rising yields do not prove rising default risk: expected inflation, monetary-policy interest rates and liquidity conditions can also affect yields.