Bond prices and yields move in opposite directions, which can be confusing if you are new to bond investing. Bond prices and yields work like an arbitrage: when bond yields rise, prices fall, and when bond yields fall, prices rise.
Bond prices rise when yields rise
When interest rates increase, demand for bonds goes up, and their prices fall. This happens largely because the bond market is controlled by supply and demand for invested money. In other words, when there is greater demand for bonds, the Treasury does not have to raise yields to attract investors.
Note: If investors are unwilling to spend money on buying bonds, their prices drop, leading to higher interest rates.
When prices rise, this can attract returning bond buyers to the market, pushing bond prices up and yields down. Conversely, a drop in bond yield from 2.6% to 2.2% actually signals positive market performance: more investors are buying bonds. You may ask why the relationship works this way, and there is a simple answer: there is no free lunch in investing.
From the time bonds are issued until their maturity date, they trade in the open market, where prices and yields fluctuate continuously. As a result, yields converge to the point where investors are receiving nearly the same yield for the same level of risk.
This prevents investors from being able to buy a 10-year U.S. Treasury bond with a yield to maturity of 8% when another one only returns 3%. It works this way for the same reason that a store cannot make its customers pay $5 for a gallon of milk when the store on the other corner is only asking for $3.
Examples of bond prices and yields moving
Let’s look at some examples that will help you understand the relationship between bond prices and yields:
Bond prices rise when yields rise
Let’s assume there is a new corporate bond, Bond A, that becomes available in the market in a certain year with a coupon yield of 4%. Interest rates rise in the following 12 months, and after one year, the same company issues a new bond called Bond B, but this bond has a yield of 4.5%.
So, why would an investor buy Bond A with a yield of 4% when they can buy Bond B with a yield of 4.5%? No one would do that, so the price of the original Bond A must be adjusted downward to attract buyers. But how much does its price drop?
This is how the math works: the original price of Bond A is $1,000 with a 4% coupon payment, and its initial yield to maturity is 4%. In other words, it pays $40 in interest every year.
Since the coupon rate or interest always remains the same, the price of Bond A must drop to $900 to maintain the same yield as Bond B. Why? Because of simple math: $40 divided by $900 equals a yield of 4.5% – the same yield as Bond B.
Over the next year, the yields on Bond A rise to 4.5% to be competitive with the prevailing rates as reflected in the 4.5% yield on Bond B.
Bond prices rise when yields fall
In this example, the opposite scenario occurs. The same company issues Bond A with a yield of 4%, but this time the yields drop. After one year, the company issues another bond, Bond C, with a yield of 3.5%. In this case, the price of Bond A adjusts upward to match its yield with Bond C.
If Bond A was issued in the market at a price of $1,000 with a 4% coupon, and its initial yield to maturity is 4%, then the price of the bond must rise to $1,142.75. As a result of this price increase, the yield or coupon payment of the bond must drop because $40 divided by $1,142.75 equals 3.5%.
Conclusion
You must
On bonds that have already been issued and continue to trade in the secondary market, their prices and yields must constantly reset to align with current interest rates.
Note: A decline in prevailing yields means that an investor can benefit from capital appreciation in addition to the yield. Conversely, rising prices can lead to capital loss, impacting the value of bonds and bond funds. Investors can find various ways to protect their assets from rising interest rates in their portfolios by hedging their investments by also investing in an inverse bond fund.
Frequently Asked Questions (FAQs)
How to calculate the price of a bond?
The value of a bond depends on its maturity, interest payment, and interest rate. In other words, the price of a bond is based on the amount of yield that the investor will receive over a certain period of time. To calculate the price, you will need to compare current interest rates (discount rate) on similar bonds, the present value of remaining payments, and the face value of the bond.
When is the right time to invest in bonds?
Generally, it is wise to invest in more bonds as you approach retirement, as bonds are considered a lower-risk investment and provide a more stable—though lower—return than stocks. It is always good to have bonds in your portfolio to protect against periods of stock market volatility.
How to invest in bonds when interest rates are rising?
When expecting rising interest rates, it is best to avoid investing in long-term bonds that may see their value erode over time. Instead, purchase short-term bonds or invest in well-diversified bond funds that will perform well in the near term.
Source: https://www.thebalancemoney.com/why-do-bond-prices-and-yields-move-in-opposite-directions-417082
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