One of the more confusing aspects of bond investing is the relationship of bond price and yield. As bond investors we want high prices and high yields but it’s just not possible. At least not at the same time. This is where the confusion begins. In a time where interest rates are at all time lows, understanding the bond price and yield relationship is important.
Bonds play an important part of every portfolio. The basic asset allocation strategy says to have your age as the percent of bonds in your portfolio. I could argue for more or less based on interest rate risk and current yields, but that’s a post for another day. The bottom line is we should have some bond exposure in our portfolio. For now, lets just stick to the basics of the bond price and yield relationship.
New bonds are issued at face value (par), with a time to maturity, and a yield (coupon rate) that involves several factors including risk. Bond yield is the return you will receive if you hold the bond till maturity. It’s in annual percentage form. So a bond with a 5% yield, will pay a 5% return each year until the bond matures.
Most of the time we view bonds as something that is bought and held till maturity. If that’s the case, the daily bond price fluctuations don’t matter. But there are investors that buy and sell bonds before maturity with the goal of selling them for a profit.
Several factors affect bond prices with interest rates having the biggest impact. As interest rates change, a bond can become more or less attractive, depending on how its yield compares to the current rates.
The Bond Price and Yield Relationship
The relationship of bond price and yield can be summed up pretty simply. As yield goes up, price goes down. And vice versa. But why?
The government issues bonds on a fairly regular basis. Let’s say it issues a $1,000 bond with a 5% yield. That yield looks good so you buy a bond, hoping to hold it to maturity. Next month rolls around and the government plans on issuing some more bonds only interest rates have risen in the past month. So it has to issue a $1,000 bond with a 6% yield. You think this is a great deal, so you try to sell that old bond, to buy the new one.
Here’s where the problem lies. No one wants to pay $1,000 for a 5% bond yield, when they can get a 6% bond yield for the same amount. In order to sell that old bond, you’d have to discount it to a lower price that will yield about 6%, just to make it worthwhile to other buyers.
The opposite is also true. Let’s say you still have that 5% bond, only this time interest rates fall, so the government issues a $1,000 bond with a 4% yield. The lower rate isn’t that appealing to you, but bond buyers are pounding down your door to buy your old 5% bond. It’s in high demand so you can charge a premium for that old bond and make a profit.
The Bond Dilemma
This brings us to the high prices and high yields dilemma. Both are a good thing. As investors we like high yields because it gives us the best return on our invested dollar. Once we own the bond, we’ve locked in the high yield, so we hope for high prices (lower interest rates). This way, if we ever sell the bond, it can be sold for a profit.
When interest rates are at all time lows, it’s hard if not impossible to go any lower. Sometimes the only direction is up, which means higher rates, lower prices in the future.