Bond yields are closely followed by share market investors as they have an impact on interest rate movements. In this article we discuss what a bond is and the difference between a bond price and bond yield.
Definition
A bond is essentially a loan. These products can be issued by a government or a corporation. When governments or companies want to raise money, they can do so by issuing bonds. When an investor buys a bond, they are lending money to an institution and in return the investor receives regular interest payments. The principle of the bond is repaid on maturity. Interest rates payment can be either a variable rate or a fixed rate to the bond owner. The interest rate used to calculate periodic payments is called the coupon rate. The coupon dates are the dates the interest payments are made to the bond owner. They are usually paid semi-annually.
Bond Yield vs Bond Prices
A bond yield is the return investors should expect from investing in the bond.
Bonds are usually issued in denominations of $1000 known as the par. Bond prices are quoted in percentage terms so this is expressed as 100 or at par.
If a 10-year bond is issued with a 5 percent interest rate (bond coupon) and interest rates go up, then this 5 per cent interest rate bond holder will struggle to sell it in the market as there are other bonds offering, say, a 6 percent coupon. To compensate for this, the 5 per cent bond holder will need to lower their bond price to make up for the difference in loss for the 1 percent interest rate coupon loss.
If interest rates drop, then this 5 per cent bond coupon becomes more attractive as newer issued bonds may have, say, a coupon rate of 4 percent. In this scenario the owner of this 5 per cent bond coupon can increase the bond price as it would be in higher demand than the newer issued ones of 4 per cent.
Therefore, there is an inverse relationship between bond prices and interest rates.
Risk
Bonds carry less risk than shares and provide stable income streams. However, bonds do not offer the same level of capital growth the way shares do. They are defensive assets and are considered safe havens in economic uncertain times. Corporate bonds may pay higher interest payments but are riskier than government bonds which pay lower interest payments.
Lauren Hua is a private client adviser at Fairmont Equities.
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