Bonds and Yields

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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.

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.

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 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.

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.

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 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.

Bonds and Yields
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