In other words, an upward change in the 10-year Treasury bond’s yield from 2.2% to 2.6% is a negative condition for the bond market, because the bond’s interest rate moves up when the bond market trends down. This happens largely because the bond market is driven by the supply and demand for investment money. Meaning, when there is more demand for bonds, the treasury won’t have to raise yields to attract investors. When rates rise, that can attract those bond buyers back to the market, driving prices back up and rates back down. Conversely, a downward move in the bond’s interest rate from 2.6% down to 2.2% actually indicates positive market performance: More investors are purchasing bonds. You may ask why the relationship works this way, and there’s a simple answer: There is no free lunch in investing. From the time bonds are issued until the date that they mature, they trade on the open market, where prices and yields continually change. As a result, yields converge to the point where investors are being paid approximately the same yield for the same level of risk. This prevents investors from being able to purchase a 10-year U.S. Treasury note with a yield to maturity of 8% when another one yields only 3%. It works this way for the same reason that a store cannot get its customers to pay $5 for a gallon of milk when the store across the street charges only $3. Let’s look at some examples that will help you gain a sense of the relationship between prices and yields on bonds.
Interest Rates Go Up
Consider a new corporate bond, Bond A, that becomes available on the market in a given year with a coupon, or interest rate, of 4%. Prevailing interest rates rise during the next 12 months, and one year later, the same company issues a new bond, called Bond B, but this one has a yield of 4.5%. So, why would an investor purchase Bond A with a yield of 4% when they could buy Bond B with a yield of 4.5%? Nobody would do that, so the original price of Bond A now needs to adjust downward to attract buyers. But how far does its price fall? Here’s how the math works: Bond A has an original price of $1,000 with a coupon payment of 4%, and its initial yield to maturity is 4%. In other words, it pays out $40 of interest each year. Because the coupon or interest rate always stays the same, Bond A’s price must fall to $900 to keep its yield the same as Bond B. Why? Because of simple math: $40 divided by $900 equates to a 4.5% yield—the same yield as Bond B. Over the course of the following year, the yield on Bond A has moved to 4.5% to be competitive with prevailing rates as reflected in the 4.5% yield on Bond B. You won’t find the relationship this exact in real life, but this simplified example helps provide an illustration of how the process works.
Bond Prices Increase
In this example, the opposite scenario occurs. The same company issues Bond A with a coupon of 4%, but this time yields fall. One year later, the company issues another bond, Bond C, with a coupon of 3.5%. In this case, the price of Bond A adjusts upward in order to match its yield with Bond C. If Bond A came to the market at $1,000 with a coupon of 4%, and its initial yield to maturity is 4%, the bond’s price must rise to $1,142.75. Due to this increase in price, the bond’s yield or interest payment must decline because the $40 coupon divided by $1,142.75 equals 3.5%.
Pulling It All Together
Bonds that already have been issued and that continue to trade in the secondary market must continually readjust their prices and yields to stay in line with current interest rates. Conversely, rising rates can lead to loss of principal, hurting the value of bonds and bond funds. Investors can find various ways to protect against rising rates in their bond portfolios, such as hedging their investment by also investing in an inverse bond fund.
