A Key Driver of Bond Yields: Governance

Through the cycle a lot of factors push and pull bond yields around, but as I was doing some research on governance rankings across countries I found an interesting yet intuitive correlation.Based on my analysis there is a discernible link between the quality of a country's governance and the level of a country's bond yield.

The chart in this article comes from a report on governance risk premia in bond yields from a recent edition of the Weekly Macro Themes report.

The chart shows 10-year government bond yields against my composite country governance ranking.

(Click on image to enlarge)

The composite governance ranking includes inputs from the IMF, World Economic Forum, and World Bank, and is designed to give a composite view of how a given country ranks overall governance-wise.

With an R2% of almost 70%, and just visually you can see there is a decent correlation.

In my view this reflects a couple of things.Firstly, there is bound to be a country risk premium aspect, in that countries with worse governance will probably have a higher risk of default or other possible impairment of capital. Second, countries with worse governance are likely to have more volatile growth, higher interest rates in general and most importantly: higher inflation.

The results are similar to the work I've done with governance risk premiums and expected equity market returns. And similarly when you adjust for such a risk premium the prospective return landscape can look very different.

Certainly, at the very least it highlights the importance of governance in country selection.