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Understanding the price fluctuation of bonds is
probably the most confusing part of this lesson. In fact, many new investors
are surprised to learn that a bond's price changes on a daily basis, just
like that of any other publicly-traded security. Up to this point, we've
talked about bonds as if every investor holds 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.
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Measuring Return With Yield
Yield is a figure that shows the return you get on a bond. The simplest
version of yield is calculated using 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 with a 10% coupon at its
$1,000 par value, the yield is 10% ($100/$1,000). Pretty simple stuff. But
if the price goes down to $800, then the yield goes up to 12.5%. |
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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 $1,200, the yield shrinks to 8.33%
($100/$1,200).
Yield To Maturity
Of course, these matters are always more complicated in real life. 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 here is that YTM is more accurate and enables you to compare
bonds with different maturities and coupons.
Putting It All Together: The Link Between Price And Yield
The relationship of yield to price can be summarized as follows: when price
goes up, yield goes down and vice versa. Technically, you'd say the bond's
price and its yield are inversely related.
Here's a commonly asked question: 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 $1,000 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, issuers
and yield. All of these characteristics of a bond play a role in its 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 newer bonds being issued with higher
coupons. 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 newer bonds being issued with lower coupons.
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