Every asset class has its own jargon or terminology. It is essential that investors are familiar with the terms used in an asset before putting their money to work. For example, when you buy equities, gold, real estate or mutual fund units – all you care about is the “price” which is the level that you can transact at.
For Bonds we use any one of the TWO terms to determine the level of transaction – price or yield. Price is simple to understand as most things that money can buy have a price. Now, as bonds are fixed income securities offering stable regular interest rate, people are focused on the total returns on their investment. This total return of any bond at a particular price is called it’s “yield”. Naturally, it is understandable that if your purchase price of an asset is ‘lower’, then your returns on it will be ‘higher’. For bonds if the ‘price’ or investment amount is lower, then the return on it or ‘yield’ is higher – establishing the relationship that for Bonds: Price and Yield move in opposite directions.
In order for us to understand the main reasons why bond prices change, let us use and example of bonds issued by a company. Let’s assume company ABC wants to borrow money today for 5 years. It does a primary bond issue at Rs.100 face value per bond and finds investor demand at 10% – implying that it will pay 10% (coupon) every year for 5 years (maturity) to investors and return everyone’s money after 5 years. Of course, nothing in life including financial markets can remain the same for 5 years! Similarly, the price of this bond may change due to the following main factors:
Let’s stay with the example above that company ABC has issued bonds for 5 years at 10% and a bondholder Mr.X has subscribed to it. Now the bondholder wants to sell this after 6 months and in that time interest rates in the economy have moved lower. Investors will come to buy this bond as it offers high interest versus other low interest options which will drive the bond price higher – let’s say to Rs.110. Now when bondholder Ms.Y buys this bond at Rs.110, the total return (or Yield) that she gets for paying this higher price is only 7.5% as she will receive Rs.10 every year for 5 years plus the principal of Rs.100 back after 5 years.
Similarly, if interest rates have moved higher or the Credit Rating of company ABC has deteriorated, investors will sell this bond to invest in other higher rated options or better companies. This will make the bond trade at Rs.90 now and Ms.Y will get a Yield of 12.8% for investing at Rs.90 – so her yield has gone higher as the bond price has gone lower.
This is represented in the simple chart below where we show yield for different prices:
As an investor, do not get confused as a bond may be quoted on it’s Price or Yield. It’s just two different ways of saying the same thing! When the investment amount goes up, returns go down and vice versa. For Bonds it’s Higher the Price – Lower the Yield. Think of it’s relation as a See-Saw!