Current 10-Year Bond Yield has been highlighted.
Bond yield is the return when purchasing a bond. Any type of bond, including government and corporate, has a certain yield or return. Government bonds are considered risk-free bonds because they are issued by the government and are denominated in domestic currency. These bonds will always be paid back since the government has the power of taxation and other sources of income for the currency bonds are denominated. When it comes to Canadian bonds, the Bank of Canada can loan funds to the Canadian government to cover the bond payments. Even risk-free bonds usually have a positive yield, which means a holder of that bond is able to get a return on it.
Depending on the coupon structure, the yield on a bond may be calculated differently. The simplest formula for finding a bond yield is as follows:
The yield calculated in this way is called a current yield. You could also divide the coupon payment by the face value of the bond in order to drive the coupon yield. When it comes to government bonds, also known as sovereign bonds, their bond yields usually indicate the expected inflation rate among investors. It is important to note that the bond's price affects the bond yield. This means that if the price of the bond increases, the buyer will have to pay more to get the same payout, which leads to a lower bond yield.
Bond maturities usually range between 1 and 30 years. The 10-year bond yield is often used as a proxy for interest rates on 10-year loans. In addition to that, investors and analysts may use 10-year bond yields in conjunction with bond yields of other maturities to assess the state of the economy. More specifically, they look at the yield curve that represents different yields for bonds of different maturities. Since the yields are affected by the sentiment of buyers, the yield curve can provide an insight into the investor's economic expectations. Usually, the yield curve has a positive slope. When the slope of the yield curve is negative, it means that the yield on short-term bonds is higher than the yield on long-term bonds. Many investors see a negatively sloped yield curve as a sign of an upcoming recession.
Positively Sloped Yield Curve
Negatively Sloped Yield Curve
Interest rates on most financial products are higher than bond yields for the respective term length. When creditors and lenders sell you a mortgage, car loan at various car loan rates, or some other product, they take on a certain amount of risk because you could default on your mortgage or you could end up repaying the mortgage early.
By lending you money, they give up the option of buying risk-free bonds which would have been default-free. Creditors and lenders will add a risk premium to compensate them for the risks associated with lending you money.
For example, let’s say you want to borrow $500,000 to buy a new house, so you ask the bank for a 10-year mortgage loan. The bank could either give you $500,000 or they could buy $500,000 worth of government bonds. Since government bonds are risk-free, all else equal, banks will prefer to buy risk-free bonds rather than lend you money. In addition to that, even if you pay a mortgage penalty, mortgages are usually repaid early when interest rates fall, so the lender would be unable to get the same interest payments as before. In either case, the bank would lose money, so to compensate them for this risk, you will be charged a higher interest rate.
There is an important relationship between the yield and the price of a bond. Yield tends to decrease as bond price increases, so the yield is controlled by the price of the bond. The price of the bond is determined on a primary market in a form of an auction. This means that the bidders determine the price at which bonds are bought, and that price affects the yields of the bonds that are used to determine the interest rates for different loan terms.
Since interest rates on financial products are directly tied to bond yields, if a 10-year bond yield increases, 10-year loan interest rates increase as well. There are also personal risk factors that may affect a personal interest rate quote. For example, a person with a lower credit score will likely receive a higher interest rate on the same loan a person with a higher credit score applies to. The difference between the 10-year government bond and interest rate is called the interest rate spread. Creditors and lenders are typically inclined to increase interest rates faster when bond yields rise to lower their exposure to the volatility of bond yields, which means that interest rate spread increases during uncertain times.
The interest rate for any financial product usually follows the bond yields. This means that when bond yields increase, the interest rate spread tends to increase while a decrease in the bond yields usually leads to a decrease in the interest rate spread. Generally, this spread is within the range of 1% and 3%, and it represents the risk premium. Since this spread is based on the risk premium, it can increase during times of uncertainty. For example, at the beginning of the Coronavirus pandemic, lenders briefly increased interest rates because default risk increased. A low interest-rate spread can be usually seen during stable times when an economy is growing and bond yields are low. As the bond yields increase, the spread may increase and stay increased for some time.
For reference, the table below shows the recent 10-year fixed mortgage rate spread that experiences an increase as the 10-year bond yield increases.
|Last Seen||10-Year Canada Bond Yield||10-Year Mortgage Rate Estimate||Spread|
Since the beginning of 2021, Canada 10-Year bond yield has been increasing steadily and reaching 3.01% yield on May 9th, 2022. This steady rise in bond yields is proportional to a 100% YoY increase in the yields. This rapid increase is due to the economic uncertainties and monetary tightening policy the Bank of Canada conducts in addition to increasing overnight rates and prime rates in Canada. During the pandemic, the Bank of Canada was buying bonds, which led to a low yield on bonds. Currently, the Bank of Canada stopped buying bonds, which led to a decrease in the price of the bonds and an increase in the yields of the bonds.
The table below provides the most recent forecasts some of the largest Canadian banks have posted. It is important to note that the forecasts have been posted on different dates, so the forecasts may have a large variance. For example, the forecast of RBC for Canada's 10-Year bond yield is 2.00% by the end of 2022. Scotiabank forecasts a 3.10% yield for the same bond and for the same date. This difference of 1.10% may be due to the fact that RBC posted the forecast in October 2021 while Scotiabank posted its forecast in May 2022. Due to current global economic conditions, bond yields are very volatile, which may lead to a large difference between the forecast and the yield. Over time, banks may change their forecasts to account for new information.
|Bank||End of 2022 Forecast|
Bond yields are the annualized returns on Government of Canada bonds. This includes the coupon payments (the bond’s interest rate) and the returns you receive from any changes in the bond's market price. Bond yields are often small in the range between 3% and 15% because the returns from price changes or capital gains are controlled by investors. Since the bonds are sold in an auction, if the investors see a bond with a high yield, they will bid the price up until the yield of the bond is in line with the market rates.
The coupon rate listed on a government bond is not what the investor receives. Instead, this rate is divided by two and, every six months, the investor receives this as a semi-annual coupon payment. The coupon payment remains fixed throughout the lifetime of the bond, however, changes in the market price of the bond can also affect returns.
If the market price of the bond is greater than the face value, then the bond yield will be lower than the coupon rate, and if the market price is less than the face value, the bond yield will be higher than the coupon rate. The most simplistic formula for finding a bond yield assumes that the face value of the bond and the price of the bond are the same. Most of the time, the face value of a bond and its price are different, so you may need to use a more general formula that should work for most bonds.
Yield to maturity gives the rate of return for a fixed income instrument. Yield to maturity (YTM) is the rate of return that equates the present value of all cash flows from a bond to its current price. In other words, YTM satisfies the following formula:
P - the price of the bond.
t - stands for time, it takes on lengths time intervals from now till each coupon payments and the principal payment.
Cash Flow - the payment a bond makes at time t.
YTM - Yield to maturity.
This formula cannot be solved analytically for YTM. Instead it is quite straight forward to implement a numeric solution in an spreadsheet.
Government of Canada bonds are issued during bond auctions, where large banks and financial institutions buy them. The bonds have fixed face values, terms, and coupon rates, which banks and financial institutions bid on.
Primary dealers or government securities distributors are institutions that are authorized to bid during Government of Canada bond auctions. Some examples of primary dealers are RBC, TD, Scotiabank, CIBC, BMO, HSBC, Desjardins, and National Bank. Once these institutions buy the bonds, they resell them to clients, so the prices you have to pay for government bonds are set by primary dealers.
If buyers on the primary market think the coupon rate on a bond is too low for current market conditions, they might only be willing to pay $99 for a bond with $100 face value. On the other hand, if the coupon payment is generous, they might be willing to pay $101 for it. This is where the bond prices come from that are used to calculate yields.
Primary dealers determine if the coupon rates on bonds are enough to compensate them for other opportunities. Just as the opportunity cost of lending is government bonds, the opportunity cost of government bonds is lending and investments. If markets are thriving, the banks and financial institutions will demand a higher coupon payment, or the price of the bond will drop.