## Bonds and Yields

## Source details

**Canonical URL:** [Bonds and Yields](https://www.imf.org/-/media/files/publications/fandd/article/2025/03/b2b.pdf)

## Other formats

- [Markdown version](/-/media/files/publications/fandd/article/2025/03/b2b.pdf.md)
- [Structured JSON version](/-/media/files/publications/fandd/article/2025/03/b2b.pdf.json)

---

### What government bonds are and how yields are determined
- Governments finance deficits by issuing bonds; bonds are promises to repay principal plus annual interest (coupon payments).
- Example: a one-year $100 bond with a coupon rate of 5 percent commits the government to pay back $105 after one year: $100 in principal and $5 in interest.
- If the coupon rate equals investors’ opportunity cost, investors will buy the bond at par ($100).
- If investors’ opportunity cost exceeds 5 percent, they will buy the bond below par. Example: if investors pay only $98, the bond’s total return (yield to maturity) is 7.1 percent, calculated as [(105÷98)-1].
- Opportunity cost components:
  - Inflation component (to preserve purchasing power).
  - Real, inflation-adjusted component (additional return forgone on alternative investments).

### Primary and secondary markets; price–yield dynamics
- Primary market: direct bond sale by government to investors.
- Secondary market: bonds trade between investors; issuance yield can differ from prevailing market yield.
- Example dynamic: if a major commercial bank fails immediately after issuance and investors expect a recession, opportunity cost can fall from 7.1 percent to 3 percent. In that case, the bond issued at $98 would trade above par at $101.95 to reflect the new market yield of 3 percent.
- Term premium: longer-term bonds usually carry a higher yield to compensate for uncertainty about future inflation and economic conditions and for forgoing other investments.

### Yield curves and what they indicate
- Yield curves plot bond maturities (horizontal axis) against market yields (vertical axis) at a given time.
- Upward-sloping yield curve: markets expect stronger future growth and higher future inflation; investors demand higher yields on longer-term bonds.
  - Example referenced: US yield curve on December 16, 2024 (red line in Chart 1).
- Inverted (downward-sloping) yield curve: markets expect slowdown, weaker inflation, and lower returns; often seen as a recession predictor.
  - Example referenced: US yield curve during/after the Federal Reserve hikes following the COVID-19 pandemic (blue line in Chart 1).
- Historical note: until recently, inversions preceded every US economic contraction for the past half century.

### Country risk premium and emerging-market yield curves
- Emerging markets and low-income countries’ yield curves convey the same information but with greater emphasis on country risk premium.
- Country risk premium arises from default risk, weaker institutions, and vulnerability to shocks leading to currency depreciation, rapid inflation, or loss of market access.
- Result: sovereign bond yields in developing economies are generally higher than in advanced economies across all maturities; the difference (spread) is an indicator of sovereign credit risk.
- When markets view debt restructuring as imminent, short-residual-maturity bond yields typically spike, producing a sharply inverted yield curve.
  - Example: March 2014 inverted yield curve for Ukrainian foreign-currency bonds signaled markets were pricing in a debt event before the 2015 restructuring; investors demanded higher yields on bonds due sooner than those due later (example contrast with 2018 maturities).

### Developing local-currency bond markets and policy guidance
- Developing local-currency government bond markets reduces reliance on foreign-currency borrowing and associated exchange rate risk.
- Requirements to develop such markets include:
  - Sound debt management.
  - Robust laws, regulations, and market infrastructure.
  - A diversified domestic investor base.
- Progress has been made in many developing economies, notably in Asia and Latin America.
- The IMF, together with the World Bank, provides active guidance to governments on developing local-currency bond markets.
- Benefits of a well-functioning government bond market:
  - Yield curve as benchmark for pricing long-term bank loans, corporate bonds, and mortgages.
  - Facilitates more efficient allocation of resources and supports long-term economic growth.

### Chart and data references (as presented)
- Chart 1: Yield curves — From booms to busts, the yield curve shows how markets expect economies to fare in the future.
- Series referenced in Chart 1:
  - US Treasury bonds (Dec. 30, 2022)
  - US Treasury bonds (Dec. 16, 2024)
  - BBB–rated LC bonds (Dec. 16, 2024)
  - Ukrainian FC bonds (March 14, 2014)

*Source: MARCH 2025, F&D article “Bonds and Yields” by S. Ali Abbas and Eriko Togo.*

---


_Source: https://www.imf.org/-/media/files/publications/fandd/article/2025/03/b2b.pdf_