Question

Tommy does not understand why yields differ among Singapore government securities and when compared to the yields on securities issued by other governments. Explain why this might be the case.

Answer 1

Reason for difference in yields between different countries -

1. Default risk - Default risk is the chance that a company or individual will be unable to make the required payments on their debt obligation. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. A higher level of risk leads to a higher required return, and in turn, a higher interest rate.

2. Prospects for economic growth. Bonds are an alternative to other forms of investment like shares and private capital. If there is strong economic growth, then the prospect for shares and private investment improves, therefore bonds become relatively less attractive and yields go up.

3. Interest rates - If Central Banks cuts base interest rates, this will tend to reduce bond yields as well. Lower interest rates on bank deposits make people look for alternatives such as government bonds.

4. Inflation - If markets fear inflation, then inflation has the capacity to reduce the real value of the bond. If you borrow £1,000 now but have inflation of 20% for the next 10 years, the £1,000 bond will rapidly decrease in value. Therefore, higher inflation will reduce demand for bonds and lead to higher bond yields.

5. Savings - If the private sector has high levels of savings, there will tend to be a higher demand for bonds because they are a good way to make use of savings, and yields will be relatively lower. Savings tend to rise during periods of uncertainty and low growth.