Bond Prices and Interest Rates

A bond is a loan, with a prearranged interest rate and due date. Yield is a general term for how much interest a bond pays. If a bond priced at \$1000 pays \$50 every year, its current yield is 5%: five dollars for every hundred dollars loaned. Its coupon is \$50 if it pays interest once a year. The relationship between interest rates and bond prices is fairly straightforward. When interest rates go up, bond prices go down. When interest rates go down, bond prices go up.

This is because in a free market all investors in the same kind of bond can get the same interest rate. The Treasury bond can serve as an example, although there are many kinds of bonds. The US government holds auctions to establish interest rates on new bonds, borrowing money for varying lengths of time. Everyone who buys a new three year treasury can get the interest rate that’s established at the auction. (The precise amount a retail customer pays may be different, depending on how he buys that bond, but the government’s price and interest rate will be essentially identical for all.) So what happens to the price of a ten year bond that was purchased when the government was paying a different interest rate, seven years ago? The price of the old bond will adjust to where it will give the same yield as the three-year bought today. That’s because they are now the same bond. Both are backed by the US treasury, have the same level of risk, and are good for three years of interest payments.

For the yields to be equivalent, the price of a bond has to move in the opposite direction as interest rates. The amount of interest paid on the bond (the coupon) won’t change; it was agreed on at the beginning, at the auction. So the price of the bond has to go down to make its interest rate higher, or up to make its interest rate lower, in order to match the rate on the new bond. It won’t be exactly an inverse movement, because of duration, because of the yield curve, and because of the difference between current yield and yield to maturity,. Current yield is the percentage of interest the bond pays every year. Yield to maturity is more complicated.

Here’s an example to show how yield to maturity works. Let’s say I need money, and I sell you a \$1000 bond that has a 10% coupon when new bonds come out yielding 20%. You may think I should sell it to you for \$500. If I did, your current yield would be 20%, because you get \$100 for your \$500 every year, but your yield to maturity would be quite a bit higher than that. You’re going to get a \$500 kicker at the end, at the maturity of the bond. The government will pay you \$1000 for the bond you bought for \$500. You can see that you don’t have to pay as little as \$500 to get 20% per year, when you have a bonus payment coming, and so I will be able to sell the bond for more than half price.

The amount that bonds rise and fall is strongly related to interest rates, but it is also related to duration. Very roughly speaking, duration is the amount of time you have to own a bond before your cost is covered. But a more useful way of thinking of duration is that it is the amount of change in a bond price that will be caused by an amount of change in an interest rate. Longer dated bonds will fall farther in price (or rise farther) than shorter ones in response to a change in interest rates because they have a longer time to go before the investor gets his investment back. They have a longer duration. On the other hand, a bond that has a higher yield tends to have a shorter duration, because the investor is getting his or her money back more quickly. Also, a bond that pays interest more frequently has a shorter duration, again because the investor is being repaid more quickly.

The yield curve also influences changes in the price of bonds. The yield curve is the way interest rates change through time. The investor who buys a ten year bond has a longer period of uncertainty before his money is returned. So generally he is paid a higher rate of interest than the buyer of a seven-year, who gets more than a five-year, and so on. This is how it normally works. Many factors can distort the yield curve, there may even be an inverted yield curve with longer bonds paying less interest than shorter, and that may be a sign of financial trouble.

In any case, investors can buy bonds without worrying so much about interest rate risk. They can ladder their bonds. They could have a bond coming due this year, one due the next, and so on out into the future. (It also works with CDs.) This way, investors don’t have to sell their 10 year when it has three years to run, and they can, if conditions warrant, buy new bonds at the current interest rate. They can take advantage of higher interest rates on longer bonds without all the uncertainty of longer bonds. This continual new buying of bonds also insulates the buyer somewhat from inflation, the biggest risk to bond buyers, as newer bonds will be priced in accordance with current inflation perceptions. Another way to insulate against inflation is to buy TIPS, inflation protected securities.

In practice, the average investor would almost never buy bonds to trade, because bonds are traded in huge lots and because the cost of doing business is just too high. An investor might buy a bond fund or a bond ETF, for diversification with a fixed stream of income, or he might buy notes, bills, or bonds directly from the government (it’s fairly easy to do), and hold them to maturity.

Two companies that run well regarded bond funds are Pimco: http://www.pimco.com/Default.htm
and Vanguard:
http://vanguard.com/