Why do bond yields go up, when bond prices go down?
You might have come across a rule which states that
When bond prices go down, bond yields go up & vice versa
Let’s understand this rule.
You will agree that when a seller of a goods sells at a lower cost, he makes a lower profit. However, the purchaser of the good makes a gain due to the attractive price of purchase.
Now let’s understand with a simple example.
Ravi has a corporate bond of Rs.100/- which gives him 10% returns per annum. In other words, the company would pay him Rs.110/- at the end of the year for the Rs.100/- loan that Ravi has given to the corporate.
The 10% yield thus translates to a Rs.10/- profit for Ravi.
Now let’s assume that Ravi has an emergency and needs money. He goes to his friend John who quickly realizes that Ravi needs money urgently. So, he makes and offer to Ravi to buy his bond for Rs.90/-. Ravi agrees to the offer and sells the bond for Rs.90/-.
At the end of the year, John receives Rs.110/- from the corporate.
Thus, John earns Rs.20/- from his investment of Rs.90/- in the corporate bond he bought from Ravi.
Thus, John’s % return (which is popularly known as the yield)works out to:
{20/90}x100 = 22.2%
Thus, while Ravi was earning a return of 10%, the sale of the bond at a lower price of Rs.90/- translated into a gain for John in terms of higher yield which went up from 10% to 22.22%.
Having understood the concept, it will not be difficult for you to appreciate the inverse relationship between the price of the bond and its yield (for the buyer of the bond).
i.e., A bond’s yield goes up when its price goes down and conversely the yield of the bond comes down when the price of the bond goes up.
When interest rates fall, it causes a fall in the value of the related investments. However, bonds that have been issued will not be affected in such a way. They will keep paying the same coupon rate as issued from the beginning, which will now be at a higher rate than the prevailing interest rate. This higher coupon rate makes these bonds attractive to investors willing to buy these bonds at a premium.
Conversely, when interest rates rise, newer bonds will pay investors better interest rates than existing bonds. Here, the old bonds are less attractive and will drop their prices as compensation and sell at a discounted price.
