What are yields? OATS, Bunds, Gilts, Treasuries Anyone?

 Hi All, 

Some people have asked me to explain this one and I agree because it is jargon that can confuse people and the economic journalists to my mind fail to explain it. 

So....

The UK government spends more than it takes in taxation. Therefore it borrows on the markets, but unlike a credit card or loan, does so by issuing a Bond or Gilt. It has this name because the edges of the paper the bonds were written had golden edges , thus HM Treasury’s debt was as good as gold itself. Many other government bonds have their own names: France's government debt is called OATS, Germany has Bunds and America has Bonds and Treasuries. 

These bonds are given to investors in exchange for immediate cash, the bond comes with an annual interest payment called the coupon. Thus Bob gives $100 to Janet Yellen and in return she gives Bob a Treasury and $5 per year. The bond can be issued for a duration of anytime under 1 year or like bank notes issues in 1, 2, 5 , 10 and even 20 years, during which Bob will still get his $5 :the UK used to issue perpetual bonds called Consols, issued from 1751, helping to pay for the seven years or the French and Indian Wars and then the American Revolutionary War and the Wars against Revolutionary France and Napoleon,  although they were paid off in 2015. At the end of the bond's lifetime, it is 'redeemed' so  Bob gets his $100 back.

The decision over the length of the bond is up to the government of the day. Interest rates also used to be decided by the government and this tended to be accepted because there were so little debt issued. Today the interest rate or coupon is decided by regular auctioning (i.e. selling) of Gilts. It is the big 'market makers' or 'stock jobbers' as they were once called who are the chiefs of this primary market. They then sell these onto the secondary marketplace, which is what most commentators and journalists are referring to when the discuss 'the bnond market', where these gilts are bought and sold . 

The yield of the gilt is the real interest rate an investor would get from the bond, taking into account that because bonds can be bought and sold, then they can go up and down in price, beyond its par or issue value, which can have a variety of reasons such as geo-political, economic, local domestic. There are different ways of calculating this effective interest rate : 

The most common calculation is the Current Yield. 

This is based on someone buying a bond and holding it for a year. 

Example 1: £100 Gilt with a coupon of 5%  and the current market value is £120. The yield or actual interest rate is 4.2% and not 5% ( £5 /£120) .

Example 2 : £100 Gilt with a coupon of 5% and the current market value is £80. The yield or actual interest rate is 6.3%. 

Example 3 : £100 Gilt with a coupon of 6% and current market value is £120, the yield or real interest rate is 5% , which is actually lower than example 2. 

Bonds do  2 other vital functions, but in this respect I refer to the Bonds issued by the OECD, which is the club of the rich developed nations. 

The first function is that bonds of the OECD are allowed to form part of Banks core capital and their ratio to their loan books. The assets of banks are specifically graded or given a mark and government bonds are given a zero or risk free grade. So the reader can see the whole issue of the Greek bailout in this context, because for the first time one of the rich club of nations was having their 'name' questioned by the markets. Now a decade later it could be Britain's turn.

The second function relates to the first. Because these OECD bonds are considered to be risk free they are used as collateral in Repro transactions (Repros are basically the banking equivalent of a pawn shop) whenever a bank needs immediate cash,via the financial markets or as a last resort via their Central Bank.

Therefore I trust that the reader can see when Bonds drastically decrease in price, because they are seen as good as gold, then there is a crisis afoot...