When a country borrows money, it issues a documentation called a bond. This document is like a contract that establishes that the county has borrowed a sum of money under stipulated conditions. One of the vital conditions is the interest rate.
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If a bond of Rs 100 carries a coupon (interest rate) of 10% pa. This means that the borrower has to pay Rs 10 at the end of the year. Now the lender can sell the bond to another buyer if one is in need of money. Under normal conditions, the lender would sell to the new buyer of the bond at a price which should earn 10% returns less the interest that the first lender is eligible based on the period of holding. In essence, the new lender would learn less than 10% at the end of the year. However, if the lender is desperate for the money and buyers know this, they are likely to negotiate and pay less than its intrinsic value. In such a case, the new lender would earn higher than 10% that was originally decided. This earning is called the yield whereas the original rate decided is called the coupon. Similarly, if the new lender is desperate to buy the bond, the seller (original lender) could sell it at a higher price and thereby make more money than the 10% coupon and thereby earn lesser yield. In essence, the gain and loss is now a function of the seller and buyer of the bond. Thus, bonds of various countries are being transacted in the market on a daily basis.
Now, in case the confidence of buyers in general decreases for a particular country, (say Greece or Spain) the sellers would not be able to get a fair price for the bond. Some sellers who panic would want to sell off at a lower price which the buyers are willing to pay. The buyer is likely to earn a higher yield because he is taking a risk of purchasing a bond of a country that is not enjoying buyer confidence. On the other hand, if the country was enjoying tremendous confidence then the buyer would be willing to buy the bonds at a premium. They would believe the price to further rise which would give them a chance to make some quick capital gains.
Therefore, when a county is either likely to default or its economic growth outlook appears dismal, its bond yields rise. It means that the market expects the country to pay more interest to lenders for the risk they are taking by lending it money.
Hence the yield rates are inversely proportional to the strength of the economy. The higher the yield rates indicate a weaker economy while lower yield rates indicate a stronger economy.
Hope this explanation makes the relationship of bond yields and a country's economy clear.
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If a bond of Rs 100 carries a coupon (interest rate) of 10% pa. This means that the borrower has to pay Rs 10 at the end of the year. Now the lender can sell the bond to another buyer if one is in need of money. Under normal conditions, the lender would sell to the new buyer of the bond at a price which should earn 10% returns less the interest that the first lender is eligible based on the period of holding. In essence, the new lender would learn less than 10% at the end of the year. However, if the lender is desperate for the money and buyers know this, they are likely to negotiate and pay less than its intrinsic value. In such a case, the new lender would earn higher than 10% that was originally decided. This earning is called the yield whereas the original rate decided is called the coupon. Similarly, if the new lender is desperate to buy the bond, the seller (original lender) could sell it at a higher price and thereby make more money than the 10% coupon and thereby earn lesser yield. In essence, the gain and loss is now a function of the seller and buyer of the bond. Thus, bonds of various countries are being transacted in the market on a daily basis.
Now, in case the confidence of buyers in general decreases for a particular country, (say Greece or Spain) the sellers would not be able to get a fair price for the bond. Some sellers who panic would want to sell off at a lower price which the buyers are willing to pay. The buyer is likely to earn a higher yield because he is taking a risk of purchasing a bond of a country that is not enjoying buyer confidence. On the other hand, if the country was enjoying tremendous confidence then the buyer would be willing to buy the bonds at a premium. They would believe the price to further rise which would give them a chance to make some quick capital gains.
Therefore, when a county is either likely to default or its economic growth outlook appears dismal, its bond yields rise. It means that the market expects the country to pay more interest to lenders for the risk they are taking by lending it money.
Hence the yield rates are inversely proportional to the strength of the economy. The higher the yield rates indicate a weaker economy while lower yield rates indicate a stronger economy.
Hope this explanation makes the relationship of bond yields and a country's economy clear.
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