Unit 4 Macro: UK Bond Yields Reach Record Lows

The yields on UK government issued bonds has been falling steadily in recent months and, as we turned into January 2012, the yield on ten year government debt edged below 2% - when the UK government continues to borrow eye-wateringly large sums, why are bond yields so low?

The yield on a bond is the income received from a fixed-interest bond, calculated as a percentage of the price paid for it. So a ten year bond bought for £10,000 and paying a fixed annual interest of £600 would offer a yield of £600 / £10,000 = 6.0% per annum.

If the market price of a bond rises - for example, it rises from £10,000 to £12,000, the fixed interest remains the same (£600) but the yield will fall. £600 / £12,000 expressed as a percentage = 5%.

Our chart above shows what has been happening to UK government bond yields. The yield has been falling and the dominant reason is that there has been a strong demand for UK government debt driving prices higher. Keep in the mind that during just two years alone, the British government (via the Bank of England) issued over £470 billion of bonds / gilts - that is a low of supply for buyers to be found, but the demand for certainly there!

So where is the demand coming from? The answer is multiple sources from home and abroad

1/ Banks are being required by law to bolster their capital reserves and hold more in the form of low-risk Treasury debt.

2/ The Bank of England has become a major buyer of government debt through their policy of quantitative easing (QE) - QE is already worth up to £275 billion and many economists are forecasting an extension of QE as we head through 2012.

3/ There has been relatively strong demand for UK government debt from overseas buyers some of whom regard the UK economy as a safe haven given financial turbulence elsewhere notably the economic woes in the Euro Zone. The pound has appreciated quite a bit against the Euro in recent months and some of this is due to strong institutional demand for UK government debt from overseas buyers

4/ Demand for UK gilts has been boosted by expectations that (i) the Bank of England is unlikely to start raising policy interest rates in the near term - they most likely will stay below 1% for the whole of 2012 and (ii) The Bank of England will expand the QE programme providing another boost to bond prices causing falling yields.

Low yields means that the cost of servicing government debt is lowered - good news for the Chancellor. But there is precious little hard evidence that lower long term interest rates in the financial markets are filtering through to those who need it most - namely small and medium-sized businesses straining to find access to affordable loans to keep afloat or to sustain a durable recovery in production, jobs and investment.

Keep in mind that Japan has for many years had very bond yields on government debt despite having the highest national debt in the developed world. And their economy struggles to climb away from a low-growth, deflation-bound situation.

Low bond yields are not a panacea for the UK’s macroeconomic fragility as the Chancellor might have us believe.