Understanding The Relationship Between Bond Prices and YieldsOctober 25, 2015
Today we try and understand the relationship between Bond Prices and Yield.
Bonds or Fixed Income products per say have been a great area of interest for investors and specially traders globally. Investment banks have always relied heavily on FICC (Fixed Income Currency Commodities) business to make profits. FICC has always been the major contributor to the banks profits.
Now let’s understand how the Fixed Income product really works and what the determining factor is for investors and traders to invest in a type of bond.
The two major components of a Bond is principal and interest. Interest component is primarily known as Coupon. But bond investment is primarily decided by calculating the Yield. Now what is Yield. Not delving into the bookish definition much, It is anticipated rate of return.
So let’s take an example now and understand how it works in a practical scenario.
A Bond say XYZ is issued on 1st Jan 2012.
- Face Value-$1000
- Coupon-6% Semi Annually
Mr. A purchased this bond on the issue date. So he would receive $60 as yearly interest in two shapes of $30(paid semi annually). Owing to the huge demand of bond the price of the bond has gone up to $1100 after one year. Mr. B who is interested in buying this bond is willing to pay $1100 to Mr. A. Mr. A is happy to sell this off as he is making $160 ($100 due to increase in bond price and $60 as coupon) which is 16% return on investment. The bond is now sold to Mr. B on 1st Jan 2013 at $1100. But the question now is will Mr. B get 6% on Face value or the price he purchased the bond. It is important to understand that bond is a debt instrument and no issuer will want to increase the liability by paying coupon on $1100.Hence coupon will be always paid on $1000 irrespective of the price the bond is purchased in the secondary market. But is that the real rate of return for Mr. B. No is the answer. Reason being he purchased the bond at $1100 and is getting coupon of 6% on FV.
Then how does Mr. B calculate is real rate of return. Well, he does this by calculating Yield.
Let us now calculate the yield of both Mr. A and Mr. B and determine the relation between Bond price and Yield. Going by the above formula.
Yield of Mr. A = 6/1000 = 0.006
Yield of Mr. B = 6/1100 = 0.005
Hence we can now deduce that bond price is inversely linked to the yield. Meaning, if bond price goes up, yield goes down and above calculation can be used to demonstrate the same.
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