Bonds are popular security for fixed income investors and people looking for stability in their portfolios. Understanding how bonds, which are essentially corporate or government IOUs, generate income requires an understanding of a bond’s price and its yield, both of which can fluctuate. Here’s how to understand bond prices and bond yields. If you are looking for a fixed income component for your investments, work with a financial advisor to find the security that best fits your risk profile, time horizon, and goals.
Basics of bonds and bond prices
The obligations have a fixed term; Usually, the term of a bond ranges from one to 30 years. In this period, there are short-term bonds (1-3 years), medium-term bonds (4-10 years) and long-term bonds (10 years or more). At the end of this term, known as the maturity date, the full nominal value of the bond is paid to investors.
Bond prices are usually expressed in face value, also known as face value. This number indicates what the bond will be worth at maturity, and it is also used to calculate the bond’s interest payments. The price you pay for a bond may be different from its face value and will change over the life of the bond, depending on factors such as the length to maturity of the bond and the interest rate environment. But the face value does not change. If it was $ 1,000 at issue, that’s exactly what the bondholder will receive when it matures at the end of its term.
The price of a bond is an estimate of the present value of the bond based on its estimated future value. This pricing works the same as stock pricing. It evolves according to external economic and market factors and the financial health of the issuer. As a result, the bond’s price may be higher or lower than its face value. They also vary among brokerages due to fees, markups or markdowns.
Why bond prices and interest rates vary
Bond interest rates and bond prices have an inverse relationship. If the interest rate on a newly issued bond exceeds the interest rate on an older bond of the same duration and type, the market price of the old bond decreases. Indeed, compared to the new bond, the old bond is less lucrative for potential buyers. Bond buyers will only buy the old bond with its lower interest rate payments if the price of that old bond is discounted.
On the other hand, consider a scenario of generally declining interest rates. In such an environment, companies will issue bonds at lower interest rates than older bonds. This makes the older bond with the comparatively higher interest rate more attractive. To compensate for this, companies issuing bonds at a lower rate must offer a discount to buyers.
Example of bond price and interest rate
Let’s say you buy a bond from ABC Corp. with a 5% coupon. Three possibilities follow:
The prevailing interest rate remains the same as the coupon rate of the bond. The face value is set at 100, which means that buyers will pay the full price of the bond.
The prevailing interest rates are increasing. Since the company will be issuing bonds at the higher interest rate, buyers will not want to buy the old bond, with its lower interest rate. Thus, the old bond must sell for a lower price than the new higher interest rate bond.
The prevailing interest rates are falling. Since the new bonds will have a lower rate, buyers will pay more for an older bond with its comparatively more generous interest rate.
Factors Affecting Price
There are three key factors to be aware of when dealing with the price of a bond:
Duration – This is important because of the sensitivity of a bond to changes in interest rates. The longer the maturity or term, the more sensitive the bond is to changes in interest rates. Since bond buyers often buy these securities for their stability and guaranteed income stream, a longer-dated bond is more vulnerable to changes in interest rates and, therefore, riskier than a long-term bond. shorter duration.
Issuer’s financial health – If an institution with poor credit offers the bond, the company must raise interest rates to attract investors. When the bond comes from a creditworthy company, interest rates are generally lower. Check a company’s credit rating with agencies like Moody’s, Standard & Poor’s or Fitch.
Inflation – This usually leads to higher interest rates and, of course, lower prices. This is because the bond may not keep up with the rate of inflation, so it pays less than the amount needed to stay ahead.
What is bond yield?
If bond prices never changed, a bond’s coupon or nominal yield and its current yield would be the same. But bonds change hands over the course of their lives, and their market prices change daily for the three reasons discussed above. As a result, its current yield varies from its coupon yield. The return is determined by taking the total income of a bond and dividing it by its price, whether that is its face value or its current market price. The result is expressed as a percentage.
Coupon yield (or nominal) – Suppose someone buys a one-year bond with a face value of $ 1,000 and an annual coupon of $ 50. Holding this bond for one year (until maturity) would result in a yield of 5%. This would be its coupon yield or its nominal yield.
Current yield – But now consider how the yield changes if the price of that same bond goes down. If the bond mentioned above is resold for $ 800, this gives a current yield of 6.25%. Of course, if the bond’s price exceeds $ 1,000, its current yield will drop below 5%. As can be seen, the price and yield vary.
Besides coupons and current returns, there are several other types of returns that fixed income investors focus on.
Yield to maturity (YTM) – This is the total return that investors earn when they hold the bond to maturity. Like the coupon or the nominal yield, it is often quoted at an annual rate but differs from the coupon rate. It does not take into account any taxes or associated brokerage fees.
Yield on call (YTC) – This is similar to yield to maturity. This is the overall return on the debt if the owner of the callable bond holds it until its call date.
Worst return (YTW) – This is the worst return you can expect. It is the lower value between the YTC and the YTM of a bond. This calculation helps you know the conservative end of a bond’s potential yield.
SEC yield – This is a return that the Securities and Exchange Commission (SEC) introduced as a standard calculation. Thus, it facilitates the comparison of bond funds.
Equivalent tax yield (TEY) – This is the yield that a taxable bond needs to match the yield of a comparable tax-exempt bond.
Bond Price Versus Yield: Why Does It Matter?
Knowing the price of a bond is no more important than knowing the yield of a bond. Both play a key role in determining which security to buy. The price of a bond explains the present value of the purchase taking into account its future value. On the other hand, the yield explains the estimated yield.
Additionally, understanding how bonds work can provide insight into the strength of the stock market. This is because usually when stocks go down, the value of bonds goes up. Investors rely on the safety of bonds when the economy slows down due to regular interest payments. Thus, knowledge of bonds can be factored into your next investment when the economy changes.
Bonds can be a complicated investment. Buyers in the secondary market often need to watch out for factors that affect them before buying. It is therefore essential to stay abreast of their fluctuations as a bond trader. However, knowing how bonds work helps any potential investor, experienced or just starting out, whether or not they invest in bonds. They offer security when diversifying a portfolio and promise more consistent income than other alternatives. Understanding how these titles work will make it easier to decide whether or not to buy in the future.
Tips for investing
Navigating the world of trading and investing individually is possible. But, extra advice never hurts. A financial advisor can help you restructure your strategy and achieve your goals. With SmartAsset’s matchmaking tool, it’s easy to find a financial advisor. In just a few minutes, you’ll have up to three local advisors ready to do the job. If you are ready, start now.
Bond investing is a great way to adjust the risk tolerance of your overall portfolio, but it can be difficult to maintain the exact balance you want between fixed income and stocks. SmartAsset’s asset allocation calculator can help you stay on course when it comes to adhering to a defined allocation of various securities.
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The article Bond Price Versus Yield: Key Differences first appeared on the SmartAsset blog.