101 Bond Yields and Market Pricing
Bond Yields and Market Pricing
The amount of return a bond earns over time is known as its yield. A bond's yield is its annual interest rate (coupon) divided by its current market price.
Things To Know
- When interest rates fall, bond prices rise and their yields fall to be consistent with current rates.
- There is an opposite relationship between the credit rating of a bond and its yield.
Yields and price: an opposite relationship
There is an opposite relationship between a bond's yield and its price. When interest rates rise, bond prices fall (they are sold at a discount from their face value) and their yields rise to be consistent with current market conditions. The buyer's yield will be higher than the seller's was because the buyer paid less for the bond, yet receives the same coupon payments while the redemption price is higher than the purchase price. For example, suppose interest rates have risen from 5 percent to 6.25 percent, meaning bond prices have fallen. You can now buy a bond with a face value of $1,000 and a coupon rate of 5 percent ($50 per year) for $800, making your bond's yield consistent with current interest rates (50/800 x 100 = 6.25%). The reverse is also true.
When interest rates fall, bond prices rise and their yields fall to be consistent with current rates. Investors selling these bonds can make a profit. For example, the price of the $1,000 bond with a 5 percent coupon now rises to $1,100 to give it a yield equivalent to current market conditions of 4.6 percent (50/1,100 x 100). Buyers may be willing to pay the extra $100 to take advantage of the higher income generated by the coupons ($50 as compared to $46 from new issues), while sellers are looking to take advantage of the opportunity to make a profit. At maturity, the buyer will receive less money ($1,000) than was paid for the bond ($1,100). This could be claimed as a capital loss, which may provide a valuable tax strategy for the investor.
Yield and credit rating: an opposite relationship
There is also an opposite relationship between the credit rating of a bond and its yield. The lower the credit rating, the more credit risk that a bond issuer could default on the payment of interest or principal on the bond. The investor requires a higher return on his/her money in exchange for accepting more risk. For this reason, a bond with a low credit rating will demonstrate a higher yield than a bond with a high credit rating. Correspondingly, a changing credit rating for a particular bond issue will affect its yield in the opposite direction.
