When delving into the world of bonds and fixed income, visualizing their dynamics can be a game-changer for understanding how they work. Imagine a teeter-totter: on the left side, we have the dollar sign representing the price, typically starting at $1,000 for most bonds. On the right side, we place a percentage to represent yield.
Price vs. Yield: A Relationship
As mentioned above, bonds are usually in denominations of $1,000 or $100, just depending on the issuer. The bond's yield is the return an investor can expect to receive from holding a bond over a specific period of time. It represents the interest income earned on a bond, typically expressed as a percentage of the bond's face value. Using those two bits of information, you can then find how much annual income you can expect to receive throughout the duration of the bond.
Let's visualize an example:
Left side: $1,000 (the bond price)
Fulcrum: 10 years (duration), $50 (annual income)
Right side: 5% yield (annual income divided by purchase amount)
In its most basic form, this is how a bond works. Next, let's see what's happens to yields as interest rates fluctuate.
Market Fluctuations
Say you decide to buy more of this bond in the secondary markets, but you notice its value has dropped to $900. That's because when interest rates rise, bond prices tend to decrease (and vice versa). This is because existing bonds with lower fixed interest rates become less attractive compared to new bonds offering higher rates. Why would someone pay the same amount for a bond with lower yield?
But despite the lower price, the investor is still earning $50 annually. For a buyer at this reduced price, the effective yield becomes 5.56% ($50 divided by $900).
This reveals a crucial concept: the interest rate market suggests that your bond should yield more than the original 5%.
Conversely, if you acquire the bond for $1,100 in the secondary market while still receiving $50 annually, the effective yield drops to roughly 4.54%. You would see this happen when interest rates drop; Investors are now willing to pay more for a bond when newly issued bonds are being offered at a lower rate.
Locked Yields and Maturity
When you hold a bond until maturity, your yield is locked in. However, if you enter the secondary market and purchase a 10-year bond in its sixth year, with four years remaining, your yield to maturity is determined by the purchase price and the annual payment.
For those who held fixed income in 2020 and 2021, examining your statements will reveal a stark difference. In 2020, finding yield was a challenge, driving up the price of fixed income. As interest rates rose, bond prices were impacted.
Listen to our last broadcast where Brian and Jeremiah discussed this concept in more detail: