What Is a Bond?
Think of a bond like a loan. When you purchase a bond, you are essentially lending money to an organization-be it a corporation, government, or another organization. They promise to pay back the face-value or “par value” amount at some point in the future. Alongside this, you receive periodic interest payments as you go. This interest pay is based on a rate called the “coupon rate,” set when a bond is issued.
How is the price of a bond determined?
A bond price is not even, it fluctuates for various reasons. Here’s the basic concept of the bond price:
This is the most significant driver in the behavior of bond prices. An increase in interest rates will result in new bond issues at higher coupon rates. Old bonds tend to be less attractive because their coupon rates are lower than those recently issued. For these older bonds to be competitive, their prices tend to decline in the market.
Coupon Rate: This is the annual rate of interest that the bond pays relative to the face value. In this respect, a coupon rate of 5% on a Rs.1,000 par value bond would amount to paying Rs.50 per year. A higher coupon rate for a bond would make the bond more valuable, especially when current market interest rates are lower than the bond’s coupon rate.
Time to Maturity: Generally, long-term bonds are very sensitive to changes in interest rates. This is because for a long duration of time, investors lock away their money, and as a consequence, the value of the bonds is very sensitive to the change in interest rates.
Price and Credit Quality: Bonds issued by highly stable financial entities, as the U.S. Government or large companies, are safer and tend to hold a higher price. Junk bonds, on the other hand, carry greater yields, but sell at lower prices because the perceived credit quality is more suspect.
Yield: The Return on a Bond Investment
The yield of a bond is the return an investor makes from the bond in question, usually expressed as a percentage. The simple way to calculate this number involves two types of yields:
Coupon Yield: Simply the coupon rate for the bond. In other words, if a bond has a coupon rate of 5%, then its yield is 5%.
Current Yield: This is a computation that indicates the bond’s annual income as a percentage of its current price, not face value. For instance, you buy the Rs.1,000 face-value bond for Rs.900 and collect Rs.50 in interest; your current yield would be close to 5.56% (Rs.50 ÷ Rs.900).
YTM stands for yield to maturity-a measure of the total return on the bond if you hold it through maturity, taking into account both interest payments and any difference between the purchase price and face value. The best way to think about all these is by example: if you buy a bond below its face value-that is, at a discount-your YTM will be greater than your current yield because you also earn the difference between the purchase price and face value over time.
Price-Yield Relationship-An Inverse Relationship
The relationship between the yields and prices of bonds is, in some ways, a seesaw: when one goes up, the other goes down. This is due to how bonds are valued in the market.
Rising Interest Rates and Falling Bond Price: Let’s assume you have a bond with a 5% coupon rate. Now, suppose the market interest rate has risen to 6%. New bonds are issued at that higher rate. Now, since your investors can achieve better returns elsewhere, your 5% bond no longer seems so attractive. To make your bond more competitive, it’s price in the market will fall. At that lower price, the yield of the bond rises in order to induce additional buyers.
Falling Interest Rate and Rising Price of a Bond: Now, the market interest rate falls to 4%. This is the time for your 5% coupon holding to look all the more attractive. So, your bond price will rise and the demand for it too. The buyers want to pay extra for that higher coupon rate – which depresses its yield. This is because yields are always calculated on the yield what you pay for the bond and its fixed interest received. So, when the price goes down, the yield goes up to compensate and vice versa.
Examples to Exemplify the Relationship
Let’s see an example to illustrate this relationship.
Bond with Face Value of Rs.1,000 and 5% Coupon: Assume this bond earns Rs.50 per year in interest. In case you bought it at face value Rs.1,000, the yield is 5% (Rs.50 ÷ Rs.1,000).
Price Drop Scenario: Now suppose market interest rates increase and the price of the bond drops to Rs.900. You are still collecting your annual Rs.50 of interest but with the yield rising to about 5.56% (Rs.50 ÷ Rs.900). This is more attractive to new buyers as they get a better return on their investment.
Price Increase Scenario: If market rates are declining and the bond price had risen to $1,100, then its yield is calculated to be about 4.55% (Rs.50 ÷ Rs.1,100). Investors will pay for a higher coupon rate, lowering the yield relative to the new price.
Why is the Price-Yield Relationship Important?
Insight into the relation between price and yield would make investment decisions much easier. For example, it would be unwise to buy long-term bonds if you expect interest rates to rise because their prices would probably fall. Short-term bonds are less affected by rate changes and represent a safer bet in a rising-rate environment.
As will be seen, bonds are less volatile than stocks but still very responsive to interest rates. The price-yield relationship helps investors measure the risk and offer a means of aligning portfolios when interest rates are most likely to go up or down.
The price-yield relationship affects your total return on a bond investment, and with a high return based on price, you should know when to buy or sell a bond to maximize your gain or minimize your loss if you can correctly estimate changes in interest rates.
The heart of fixed-income investing centres around bond pricing and yields, which are one of the fundamental concepts supporting bonds: inverse price-yield relationship. Translated, this relationship means whenever bond prices decrease, yields tend to rise, and vice versa-good times bad-tug-of-war relationship in terms of market interest rates. This concept helps you understand better-informed investment choices concerning the bond market.