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What is The Relationship Between Bond Yield And Bond Price

31 May 2023

Introduction 

  • Bond prices are important indicators of all future economic activities, including interest rates.
  • They play a crucial role in maintaining a diversified and well-managed investment portfolio.
  • Bond rates, prices, and yields are ever-changing as they keep fluctuating. 
  • Whereas bond yields are discount rates that link the bond’s cash price to the current dollar price. 

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What are Bond Prices and Bond Yields?

  • The bond price is the face value of the bond at the time of its purchase. 
  • The bond yield matches the bond’s coupon rate, which is the recurrent distribution received by the holder.
  • The coupon rate of the bond sold, although fixed, is open to fluctuations in the market.
  • For instance, if you bought a bond three years ago at an interest rate of 1%, now, at the time of its maturity, you’ll get only that much. It means that the face value of the bond will return to it even though its value might have changed many times over the past three years. 
  • Bonds can only be sold, depending on their face value, at either a discount or a premium. Hence, if you bought a bond for Rs. 10,000 at issuance, the rate at the time at which you sold the bond can either be less or less than that because bond rates depend on external factors, like the existing interest rates. 

What are Premium and Discount Prices?

  • The desirability of the bond is directly related to its coupon rate.
  • If the bond has a higher coupon rate today than it did at the time it was issued, it will become more desirable in the market.
  • This means that the investor will now receive interest from the premium bond. 
  • The pattern is the same for discounted bonds, too.
  • The bond has to be sold at a lower rate than its face value at the time of issuance because of the lower coupon rates corresponding to that bond.

Why are Bond Yields Important?

  • Bond yields connect a bond’s cash flows to its dollar price.
  • They contain coupon payments and principal returns. 
  • The principal is only returned at the end of its maturity date. 
  • To put it differently, the discount factor is the bond yield.
  • The discount factor for each cash flow is calculated using the same cash flow. Therefore, bond yields are an important factor to consider in the bond market.

What is the Relationship Between Bond Price and Bond Yield?

  • The yield is the effective interest rate on bonds.
  • The relationship between bond yield and bond price is that both are inversely proportional to each other. When one increases, the other decreases, and vice versa. 
  • The mathematical expression for the relationship between the two is:

              Yield= (Coupon/Market Price of Bond) X 100

  • The bond interest payouts are fixed. If the bond price increases, it means that the buyer has to pay more for the same face value; hence, the effective returns are certainly less. 

What is the Reason Behind the Inverse Relationship?

  • As mentioned earlier, the secondary market is never still, and the bond rates and interest percentages keep fluctuating.
  • With a rise in interest rates, investment opportunities to earn higher profits increase too.
  • A bond issued at 2% interest initially could now be outdated if the market rates of interest reach, say, 6%. 
  • The coupon rate does not change and remains the same at 2%. The higher price of the bond translates into a lower yield for the investor, and vice versa.

FAQs

1. What is the bond price?

The bond price is the current value of the future cash flows related to the bond. These rise and fall with the market rates, demand, and supply.

2. What are coupon rates?

They are entirely based on the bond’s face value and the interest rates the issuer has to pay the buyer at regular intervals.

3. What is the face value of a bond?

Face value is the money that is paid by the bond issuer to the holder at the time of the bond's maturity.

4. What is the yield to maturity?

It refers to the total return that a bond can provide if held until its maturity period.

5. What is a bond yield?

Represented as a percentage, bond yield is the expected earning of a bond over time. 

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