The U.S. bond market has been making headlines in recent weeks as bond yields reach rates not seen since 2007. But what exactly are bond yields, and what causes them to rise? Here, Stanford finance Professor Hanno Lustig, an expert on U.S. public debt, explains why rates are rising right now and what that means for the broader market.

Can you start with a brief overview of the U.S. bond market and how it works? 

Quite often, the government runs deficits, meaning it spends more than it takes in from tax revenue. To finance the deficit – the gap between what the federal government takes in and what it spends – the government has the U.S. Treasury auction off debt in the form of bills, notes, and bonds. These are different instruments with different maturities, but each is essentially a promise by the Treasury to repay a fixed amount of principal – say $1 – on a set future date: one year out for a bill, and five, 10, 20, or 30 years out for notes and bonds. Until that security matures, the Treasury also makes regular interest payments, called coupons, usually every six months. So the holder collects coupons twice a year and gets the principal back at maturity.

Basically, it’s how the federal government has been keeping the lights on.

Historically, the U.S. has been in a privileged position because of a strong demand for U.S. Treasury bonds, including from foreign investors. It used to be the case that when bad things happened in the world – like the Great Financial Crisis of 2008 – foreigners rushed to buy U.S. Treasuries, a phenomenon called “flight to safety.” There was something about having the U.S. Treasury stamp on a bond, compared with other issuers like corporations, that made people feel safe about their investment – so much so that they were willing to pay a little bit extra for that security.

As a result, the federal government has been able to sell bonds at a premium relative to their value, that is, what they’re really worth. That’s been great for U.S. taxpayers because it reduces the U.S. government’s borrowing costs. In other words, the U.S. government has effectively been borrowing at a lower yield or interest rate.

What is a bond yield?

The bond yield is the annual return an investor earns from holding the bond until maturity, expressed as a percentage of its price. When bond prices fall, yields rise, and vice versa.

Why are bond yields rising right now?

Bond yields rise for a number of reasons.

One is that investors expect interest rates to rise in the future. But it’s also because investors perceive 10-year bonds as riskier. If something bad happens – say inflation suddenly goes up, which erodes the value of these promises to bondholders – they are going to take a bigger loss on their 10-year bond than they would with a one-year bond. As a result, a buyer wants to be compensated for taking on that risk, which is a concept known as the “term premium.” They will receive an additional return by buying a 10-year bond instead of a one-year bond and rolling it over.

Another reason bond yields have risen now is that the safety premium is disappearing. People don’t have as much faith in the fundamental safety of Treasuries as they used to, and many investors are increasingly concerned about the U.S. fiscal situation.

Why are investors nervous?

The federal government has been running deficits for the past 25 years. The Congressional Budget Office (CBO) projects that the federal government will continue to run large deficits for the next 30 years. A major reason is promises to older Americans through Medicare, Medicaid, and Social Security. Keeping those promises means the federal government will run deficits.

But the government has also made promises to bondholders. At some point, the government will have to figure out which promises to keep and which to renege on. That’s a politically difficult call to make.

The federal government is spending an increasing share of its tax revenue on interest expenditures, which go to bondholders – the investors who own Treasury securities. That includes domestic holders (individuals, pension funds, mutual funds, banks, and the Federal Reserve) and foreign holders (foreign central banks, governments, and private investors).

Right now, the U.S. spends between 3-4% of its GDP on interest, which, to give you an idea, is the equivalent of the defense budget. If you look at the CBO projections, to reduce the deficit, policymakers have to accept continued interest costs of 3-4% of GDP, cut spending, or raise taxes – and none of those is easy.

This is not unique to the U.S. If you look at most Eurozone countries, they face similar fiscal predicaments. The key difference is that the U.S. economy is still growing, and, hopefully, with AI, it will deliver additional growth. Economic growth solves a lot of these problems.

How does the bond market impact mortgages, car loans, and other kinds of consumer borrowing?

The key point is that yields on U.S. Treasuries serve as the benchmark for essentially all other fixed-income borrowing. Rates on fixed-rate mortgages and car loans are tied directly to those Treasury yields. Lenders start from the relevant Treasury yield and then add a spread on top to compensate for risk, such as the chance that a household defaults on its mortgage or car loan. So when Treasury yields rise, the rates households pay on mortgages, auto loans, and other forms of consumer borrowing tend to rise right along with them, and when yields fall, that borrowing gets cheaper. That is the channel through which the bond market reaches ordinary people’s monthly payments.