By: Dr. Mike Campbell
The yield on a bond is the amount of interest that the issuer will pay to the investor for purchasing the debt. The higher the investment grade of the bond is, the more certain it is that an investor will be repaid his money when the bond falls due and, consequently, the lower the yield.
Conversely, if the perception of risk (of a default) associated with a bond issue rises, then the issuer will have to offer a higher yield to attract investors in the first place and adequately compensate them for the higher perceived risk.
Governments use bond issues as a way of raising money to fund major projects or simply to have the funds available to balance the budget. Just about every major economy has a substantial debt burden because they have borrowed money in this way to finance their activities.
Traditionally, most government debt was regarded as a low risk investment with a guaranteed return of monies at the end of the bond’s lifetime. The perceived risk of a modern democracy defaulting on its debts was seen to be very remote and consequently yields were modest. However, the Greek debt crisis has changed all that.
In the aftermath of the global financial crisis, questions were first raised about the ability of Greece to meet its financial obligations, causing yields on Greek bonds to spike. Next in line (and for different reasons) came Ireland. Yesterday, yields on Portuguese government 10 year bonds increased for the fourth straight day to a record 7.16%.
The Portuguese government (like the Irish before them) insist that they can continue to meet their obligations and European authorities say that there has been no discussion of a potential EU/IMF bailout. The next Portuguese government bond auction is tomorrow and analysts will be watching the uptake carefully for signs that another round of the sovereign debt crisis is about to unfold.