Yield, Price & Other Areas of Confusion
The price fluctuation of bonds is probably the most confusing part of this tutorial. In fact, many new investors are surprised to learn that a bond's price, just like that of any other publicly-traded security, changes on a daily basis! Here's the thing: so far we've talked about bonds as if everybody held them to maturity. It's true that if you do this, you're guaranteed to get your principal back; however, a bond does not have to be held to maturity. At any time a bond can be sold in the open market, where the price can fluctuate, sometimes dramatically. We'll get to how price changes in a bit. First we need to introduce the concept of yield.
Measuring Return With Yield
Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated by the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.
Let's demonstrate this with an example. If you buy a bond at its $1000 par value with a 10% coupon the yield is 10% ($100/$1000). Pretty simple stuff. But if the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely if the bond goes up in price to $1200 the yield shrinks to 8.33% ($100/$1200).
Yield to Maturity
Of course, in real life things tend to be more complicated. When bond investors refer to yield, they are usually referring to yield to maturity (YTM ). YTM is a more advanced yield calculation that shows the total return you will receive if you hold the bond to maturity. It equals all the interest payments you will receive (and assumes that you will reinvest the interest payment at the same rate as the current yield on the bond) plus any gain (if you purchased at a discount) or loss (if you purchased at a premium).
Knowing how to calculate YTM isn't important right now. In fact the calculation is rather sophisticated and beyond the scope of this tutorial. The key point about YTM is that it's more accurate and enables you to compare bonds with different maturities and coupons.
Putting It All Together: The Link Between Price and Yield
The yield's relationship with price can be summarized as follows: When price goes up, yield goes down and vice versa. Technically you'd say the bond's prices and its yield are inversely related.
Here's a main point of confusion. How can high yields and high prices both be good when they can't happen at the same time? The answer depends on your point of view. If you are a bond buyer you want high yields. A buyer wants to pay $800 for the $1000 bond, which gives the bond a high yield of 12.5%. On the other hand, if you already own a bond, you've locked in your interest rate, so you hope the price of the bond goes up. This way you can cash out by selling your bond in the future.
Price in the Market
So far we've discussed the factors of face value, coupon, maturity, the issuer, as well as yield. All of these bond characteristics play a role in a bond's price. However, the factor that influences a bond more than any other is the level of prevailing interest rates in the economy. When interest rates rise, the prices of bonds in the market fall, thereby raising the yield of the older bonds and bringing them into line with the newer bonds being issued with a higher coupon. And, when interest rates fall, the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them into line with the newer bonds being issued with a lower coupon.