Bond prices and yields

Bond prices and yields move in opposite directions, which can be confusing for those new to bond investing. Bond prices and yields move like a seesaw: When bond yields go up, prices go down, and when bond yields go down, prices go up. **If investors are unwilling to spend money to buy bonds, their price falls and interest rates rise.

When rates go up, bond buyers can return to the market, causing prices to rise and rates to fall. Conversely, a downward change in the bond interest rate, from 2.6 per cent to 2.2 per cent, indicates a positive market performance: more investors buy bonds. One may ask why this relationship works this way, and the answer is simple: There is no such thing as a free lunch in investing.

From the moment of issuance until the maturity date, bonds are traded on the open market, where prices and yields are constantly changing. As a result, yields converge to the point where investors receive roughly the same return for the same level of risk1 .

This prevents investors from buying a 10-year US Treasury bond with a yield to maturity of 8% when another bond yields only 3%. This works for the same reason that a shop cannot convince its customers to pay $5 for a gallon of milk when the shop across the street only charges $3.

Let’s look at some examples that will help you understand the relationship between bond prices and yields.

Interest rates go up

Consider a new corporate bond, bond A, available on the market in a given year with a coupon, or interest rate, of 4%. Prevailing interest rates rise over the next 12 months and a year later the same company issues a new bond, called Bond B, but with a yield of 4.5%.

So why would an investor buy Bond A with a yield of 4% when he could buy Bond B with a yield of 4.5%? No one would, so the original price of Bond A must now fall to attract buyers. But by how much does the price fall?

Here is how the calculation works: Bond A has an original price of $1,000 with a coupon of 4% and an initial yield to maturity of 4%. In other words, it pays $40 in interest every year.

Since the coupon or interest rate always remains the same, the price of bond A must fall to $900 to maintain the same yield as bond B. Why? Because of a simple mathematical question: $40 divided by $900 equals a yield of 4.5% - the same yield as Bond B.

Over the course of the following year, the yield on Bond A changed to 4.5% in order to be competitive with prevailing rates, as reflected by the 4.5% yield on Bond B.

It is not possible to find such an exact relationship in real life, but this simplified example helps to illustrate how the process works.

Bond prices rise

In this example, the opposite scenario occurs. The same company issues bond A with a 4% coupon, but this time yields go down. One year later, the company issues another bond, bond C, with a coupon of 3.5%. In this case, the price of bond A is adjusted upwards to match the yield of bond C.

If bond A was placed on the market at $1,000 with a coupon of 4% and its initial yield to maturity is 4%, the price of the bond must rise to $1,142.75. Because of this price increase, the bond’s yield or interest payment must decrease because the coupon of $40 divided by $1,142.75 is equal.

How to solve the problem

Bonds that have already been issued and continue to be traded on the secondary market must continually adjust their prices and yields to stay in line with current interest rates.

**A fall in prevailing yields means that the investor can benefit from capital appreciation as well as yield.

Conversely, a rise in rates can lead to a loss of capital, damaging the value of bonds and bond funds. Investors can find various ways to protect themselves against rising rates in their bond portfolios, e.g. by hedging their investment with a reverse bond fund.

In other words, an upward change in the yield of the 10-year Treasury from 2.2 % to 2.6 % is a negative condition for the bond market, because the interest rate of the bond market tends to fall. This happens mainly because the bond market is driven by the supply and demand for investment money. In other words, when there is more demand for bonds, Treasuries will not have to increase yields to attract investors.

How is the price of a bond calculated?

The value of a bond is based on the maturity term, the coupon payment and the interest rate. In other words, the price of a bond depends on how much the investor will earn from it over a certain period of time. To calculate the price, it is necessary to compare today’s rates (the discount rate) of similar bonds, the present value of the remaining payments and the nominal value of the bond.

When is the right time to invest in bonds?

In general, it is advisable to invest in more bonds the closer you get to retirement, as bonds are a less risky investment and offer a more constant, but lower, return than stocks. It is always good to have bonds in your portfolio to protect yourself against periods of stock market volatility.

How to invest in bonds when interest rates rise?

When interest rates are expected to rise, it is best to avoid investing in long-term bonds, which could see their value erode over time. Instead, it is better to buy short-term bonds or invest in well-diversified bond mutual funds, which will perform well in the short term.