What are bonds, how do they work, and why does the bond market matter?

Bond markets are getting a lot of attention at the moment. They help shape interest rates, which can flow through into mortgages, superannuation returns, business investment and government budgets. They are also the benchmark against which other investment returns are generally assessed.

Some bonds can also be bought by everyday investors and many people are exposed to them indirectly through their super.

But many people are not familiar with what bonds are, or how the markets around them work. So, let’s see what they’re all about.

What is a bond?

Put simply, a bond is a financial contract that provides a mechanism to borrow capital. When an investor buys a bond, they are lending money to whoever issued it. In return, the borrower promises to make regular interest payments and repay the original amount at the end of a fixed term.

So if the Australian Government sells a 10-year bond, investors are lending money to the government for 10 years.

How is a bond different from a normal loan?

A normal loan, like one for a car or renovation, usually stays between the same borrower and lender over its term.

A bond can work differently, with the bond’s initial buyer often able to sell it to someone else in what’s known as the secondary market. The borrower still has to make the payments, but the person or institution receiving those payments can change.

That creates a bond market, with investors buying and sell existing bonds, and each trade helping set a market price.

Someone might sell a bond because they need cash, want to reduce risk, or think they can get a better return somewhere else. You might buy the bond because you want the regular payments, trust the borrower, or think the price has fallen enough to make the return attractive.

How are bonds sold?

Bonds are often initially sold through auctions, tenders or syndicated deals, meaning the price can go up and down with demand as investors bid for a piece of the bond.

If lots of investors want the bond, the borrower may be able to offer a lower interest rate, making their borrowing cheaper. If investors are less keen, a higher return might need to be offered to attract enough buyers, making borrowing more expensive.

Bond prices vs bond yields

When people talk about the cost of borrowing, they normally mean interest rates, but in the bond market, that return is usually called the “yield to maturity”, often simply referred to as the yield.

That means there are usually two “prices” discussed for bonds: the price the investor pays to buy it, and the yield to maturity, which is the annual return they expect from it.  Those prices move in an opposite direction, with yields going up as bond prices fall (and vice versa).

A bond’s price is based on what investors are willing to pay today for money they expect to receive in the future. Those future payments usually include the regular interest payments throughout the term of the bond, as well as the final repayment.

The safer and more attractive those payments look, the more investors may be willing to pay for the bond. If they look risky, a higher yield may be required to entice investors, which is one reason government bond yields are sometimes used as a proxy measure of economic confidence.

What affects the return offered on a new bond?

When a government, bank or company sells a new bond, it has to offer enough return to attract buyers. Several things can influence the rate it sets.

The cash rate In Australia, that’s the interest rate set by the RBA. It has a big influence on short-term interest rates and on what investors expect other interest rates to do.

Inflation: If prices are rising quickly, investors usually want a higher return, because the money they receive in the future may not buy as much as it does today.

Time: Lending money for 10 years is usually riskier than lending it for one year.

Trust: A borrower seen as safer can usually borrow more cheaply than a borrower seen as riskier.

Supply and demand: If a government or company needs to borrow a lot of money, it may need to offer a higher return to attract enough buyers as there is a competition for capital.

Different types of bonds

The bonds most often mentioned in the news are government bonds, like US Government Treasuries, which are normally traded by big investors such as super funds and banks.

But governments can sometimes also issue bonds designed for everyday investors. During wartime for example, Australian governments have asked the public to lend directly by buying war bonds or similar products. Australian Savings Bonds, often marketed as “Aussie Bonds”, were sold to direct savers in the early 1980s.

In Australia, some federal government bonds can also be bought and sold on the ASX.

Corporate bonds issued by companies can offer higher returns than government bonds, but usually come with more risk. Corporate bonds are mostly issued and traded outside the sharemarket, and the minimum amount required to buy them can be large.

Why are bonds in the news right now

Bond yields have climbed sharply across major economies as investors reassess where interest rates may settle over the longer term.

Higher bond yields usually suggest investors expect stronger growth, higher inflation, higher interest rates, or greater risk.

In Australia, the 10-year government bond yield reached around 5.15% in early September, its highest level since 2011. Australia's 30-year yield was also at its highest since that bond was first issued in 2016, while US 30-year yields were around their highest levels in more than 20 years.

CommBank Head of Market Strategy and Rates Research Adam Donaldson says the shift reflects something bigger than the normal day-to-day movement in markets.

“What you're seeing is a change, a structural change that's occurred over a number of years, but a 30-year period where yields and interest rates were falling is now being reversed,” Donaldson says.

That matters because government bond yields are benchmarks for borrowing costs elsewhere in the economy.

“They're a benchmark for all other fixed rates in the economy,” Donaldson says.

There is also a budget angle. The federal agency that issues Australia’s government bonds, the Australian Office of Financial Management (AOFM[XC1] ) expects the federal government to borrow about $125 billion through Treasury Bonds, including Green Treasury Bonds, in 2026-27.

Donaldson says that number matters because it is lower than investors had been expecting a year earlier, and because Australia’s longer-term debt position looks more manageable than in many comparable countries.

What is moving bond markets now?

Several forces are pushing global bond yields higher, but the latest increase isn't principally an inflation story.

Governments issue special inflation-linked bonds that allow investors to compare returns with conventional bonds and get an indication of what the market expects inflation to average over time.

Donaldson says those longer-term inflation expectations have not moved dramatically in either Australia or the US. Instead, much of the latest rise in yields has come through higher “real yields”. Put simply, that's the return on a bond after expected inflation is taken into account.

“The cash rate part has been the dominant part of the story this year,” Donaldson said.

In other words, investors increasingly expect central bank cash rates to average at higher levels over the long term than they did before the pandemic.

One reason is that governments and businesses around the world are competing for more capital to fund investment.

Artificial intelligence and data centres require major spending on technology, energy and construction. Governments are also increasing defence spending, while the transition to lower-emissions energy requires further investment.

“There's a global boom underway in various investments,” Donaldson says.

Government borrowing is another part of the equation.

If governments need to issue large amounts of debt, investors may demand higher yields to absorb that supply. Concerns about how governments manage their debt can also increase the extra return investors demand for lending money over long periods.

That extra return is sometimes called the “term premium”.

Donaldson says the term premium has risen significantly in the US over the past five years as investors have become less willing to hold long-term debt without additional compensation.

The US is attracting particular attention because of its large budget deficit and rising debt, although Donaldson does not expect an imminent debt crisis.

“We probably look at this as more of a slow burn,” he says.

How is Australia placed?

Australia is exposed to the same global forces, but CommBank sees some important differences.

Australia's fiscal position compares favourably with a number of major economies, while its large superannuation system creates a growing pool of savings looking for investments.

There is also increasing overseas demand for Australian-dollar bonds issued by governments, banks and companies, a trend CommBank has described as “Aussie dollarisation”. Australian-dollar capital market issuance has reached a record high for the year to date, Donaldson says.

How do bonds affect Australia’s everyday economy?

The links between bonds and the economy most Australians experience in their everyday lives are indirect but important.

For mortgages, variable rates are most directly linked to the RBA cash rate. But fixed mortgage rates are more closely connected to bond markets, because banks look at the cost of borrowing money for a set period.

For super, bonds can affect returns even if you never buy a bond yourself. Many super funds hold bonds because they can provide income and balance against riskier assets.

For businesses, higher bond yields can make borrowing more expensive. That can affect whether companies expand, hire, build or invest.

For taxpayers, bond yields matter because governments borrow by selling bonds. If new bonds have to offer higher returns, the interest bill on new government borrowing can rise. That can affect future budgets, because more money may need to go toward interest costs.

Bond markets can also provide clues about where investors think interest rates may settle over the longer term.

For the Australian dollar, demand for Australian bonds can also matter. More overseas demand for bonds in Australian dollars can support demand for the currency, although the exchange rate is also moved by many other forces.

Bottom line

Bond markets matter because they help shape interest rates across the economy. Even if you never buy a bond, they can flow through to mortgages, super, business costs, government budgets and investment decisions.