Bonds allow companies and governments to borrow money from investors, but not all bonds are created equal. Some pay very high rates of return, or yields, while others pay zero or negative yields. Four major factors explain the variability of bond yields.
Risk of Default
Risk of default usually is the single most important factor affecting bond yields. A bond essentially serves as a loan to a government or company. Just like an individual with bad credit has to pay extra interest on a car loan to compensate the lender for the additional risk of a default, so too do governments and companies issuing bonds on the private market. In 2015, for example, yields on short-term Greek bonds were very high, because investors saw Greece as a very risky economic environment.
Normally, long-term bonds offer higher yields than short-term bonds. When the opposite is true and short-term bonds offer higher yields, it suggests investors think there is a high risk of short-term defaults. This is called an inverted yield curve.
Private Sector Savings Rate
Another factor influencing bond yields is the private sector's saving rate -- a measure of how much money businesses and individuals are socking away for the future. When the savings rate is very low, bond yields tend to rise. That's because bonds are a form a savings. When nobody is saving money, nobody is looking to buy bonds. That means issuers must offer higher rates of return to attract buyers.
When the savings rate is very high, the opposite is true. Bond yields tend to drop dramatically because investors are competing for the chance to lend money, which drives the price of debt down. In periods of high demand, bond yields actually can become negative. That means investors are paying for the privilege of lending money.
The availability of other investment opportunities also affects bond yields. Imagine you had $100,000 to invest however you liked. If you were completely sure the stock market would rise by 10 percent over the next year, it would be silly to buy a bond paying a 5 percent yield over the same time period. You'd be leaving money on the table.
When investors think that growth across the whole economy will be very strong, bond yields tend to go up. Investors have lots of options available, so they demand higher rates of returns on bonds to compensate for opportunity cost of not investing in other areas like stocks.
When the overall economy looks weak, the opposite is true. Bond yields tend to fall because investors don't see any productive alternatives for their money.
Last but not least, the perceived risk of inflation influences bond yields. That's because inflation can completely erase earnings if the rate of inflation is higher than the rate of the bond. If you buy a $1,000 one-year bond with a 5 percent yield, you stand to earn $50 at the end of the year. If the inflation rate during that year is 10 percent, however, inflation will cost you $100. Investing in that bond would actually cost you money. Thus, high inflation risk means higher bond yields.
Nick Robinson is a writer, instructor and graduate student. Before deciding to pursue an advanced degree, he worked as a teacher and administrator at three different colleges and universities, and as an education coach for Inside Track. Most of Robinson's writing centers on education and travel.