## Bonds and Yields

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**Canonical URL:** [Bonds and Yields](https://www.imf.org/en/publications/fandd/issues/2025/03/back-to-basics-bonds-and-yields-s-ali-abbas)

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## Bibliographic details
- Authors: Ali Abbas, ERIKO TOGO
- Published: March 3, 2025

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### Overview
- Global market in government sovereign debt is worth about $100 trillion.
- Yield curves plot bonds’ maturities (horizontal axis) against their market yields at a given time (vertical axis) and indicate market expectations about an economy’s future strength or weakness.
- Authors: S. M. ALI ABBAS (deputy director, IMF Fiscal Affairs Department) and ERIKO TOGO (deputy division chief, Monetary and Capital Markets Department).
- Publication: F&D Magazine, March 2025.

### How government bonds work
- Governments can finance a fiscal deficit (example: outlays exceed revenues by $100) by issuing bonds.
- A bond is a promise to repay principal at a future date plus annual interest (coupon payment) to compensate for the opportunity cost of funds.
- Opportunity cost components:
  - Inflation component (to preserve purchasing power).
  - Real, inflation-adjusted component (additional return forgone on alternative investments).
- Higher expected inflation and higher returns on alternatives raise the return a government must offer.

### Numerical example of yield and price mechanics
- Example bond: one-year $100 bond with a coupon rate of 5 percent → commitment to pay back $105 after one year ($100 principal + $5 interest).
- If coupon rate equals investors’ opportunity cost, bond sells at par ($100).
- If investors’ opportunity cost exceeds 5 percent and they will pay only $98, the bond’s return equals 7.1 percent calculated as [(105÷98)-1].
- Yield to maturity definition: the total return that equals investors’ opportunity cost.

### Primary and secondary markets (market yield changes)
- Primary market: direct sale by government to investors.
- Secondary market: bonds change hands among investors; issuance yield can differ from prevailing market yield.
- Example shock: bank failure leads investors to expect smaller returns and lower inflation; opportunity cost falls from 7.1 percent to 3 percent.
  - The bond issued at $98 would then trade at $101.95 in the secondary market to reflect the new market yield of 3 percent.

### Term premium and yield curve shapes
- Governments issue bonds across maturities, typically ranging from 1 to 30 years; each bond has its own coupon and yield to maturity.
- Longer-term bonds usually carry a higher yield (term premium) to compensate for uncertainty about future inflation and economic conditions and for forgoing other investments.
- Upward-sloping yield curve: markets expect economic growth acceleration and higher future inflation (example: US on December 16, 2024 — red line).
- Inverted yield curve: can occur when monetary tightening (e.g., Federal Reserve hikes) fuels expectations of slowdown and weaker inflation; was observed following the COVID-19 inflation spike (blue line).
- Historical observation: an inverted yield curve is often seen as a recession predictor and, until recently, inversions preceded every US economic contraction for the past half century.

### Country risk premium and emerging markets
- Yield curves in emerging and low-income countries reflect both macro outlook and a stronger focus on country risk premium.
- Developing economies often have weaker institutions and are more prone to shocks (currency depreciations, rapid inflation, loss of market funding), raising default risk.
- Foreign-currency debt increases the chance that governments must restructure debt (change repayment profile, yield, or both), raising sovereign bond yields across maturities relative to advanced economies (the spread).
- When markets price imminent restructuring, short-maturity bond yields typically spike, producing a sharply inverted yield curve.
  - Example: early 2014 inverted yield curve in Ukraine signaled markets were pricing in a debt event before the 2015 restructuring (shorter residual maturities due in 2015 demanded higher yields than those due in 2018 — yellow line).

### Developing local-currency bond markets and policy implications
- Developing local-currency government bond markets reduce reliance on foreign-currency borrowing and associated exchange rate risk.
- Requirements for vibrant local-currency bond markets include:
  - Sound debt management.
  - Robust laws, regulations, and market infrastructure.
  - Diversified domestic investor base.
- Building these elements takes time but yields substantial rewards:
  - A well-functioning government yield curve serves as a benchmark for pricing long-term bank loans, corporate bonds, and mortgages.
  - Facilitates more efficient allocation of resources and supports long-term economic growth.
- The IMF, together with the World Bank, provides active guidance to governments on developing local-currency bond markets.
- Noted progress: many developing economies, notably in Asia and Latin America, have made progress in recent decades.

*F&D Magazine — "Bonds and Yields", S. M. ALI ABBAS and ERIKO TOGO, March 2025.*

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_Source: https://www.imf.org/en/publications/fandd/issues/2025/03/back-to-basics-bonds-and-yields-s-ali-abbas_