Bonds can be confusing at first to anyone new to it. The common features in bonds which may cause confusion are:
- When Bond yields go up, the Bond price comes down and vice versa.
- When Stock Market goes up, the Bond Market goes down and vice versa.
There is nothing special about the Bond Price which is the amount you pay to buy a bond or amount you receive when you sell a bond, just like anything else in any market.
Also there is nothing special in the definition of the simple yield of a Bond. The yield is like the fixed interest you get at regular periods (when you are still owner of the bond) divided by the price you paid.
To get to the point of when to invest in bonds, we should clear up why yield going up will lead to price coming down. Say I buy a 10year bond with 5% yield at $1000. By definition, at the end of the life of the bond (10 years), the owner will get back $1000. Along the way, the owner will get 5% interest or $50.
Imagine sometime before the 10 years, the bond on the market is priced at $800. If I need to sell the bond, and someone else buy it, it would be $800. The new owner will still get $50 interest based on the price of $800. Hence the yield has increased.
In the reverse case, when the price on the market for the same bond is $1200, the new owner still get $50 interest at regular period. Since the new owner paid $1200 but get only $50, so the yield is lower than the original 5%.
So that is the mechanics of why bond yield is inverse to bond price. But what drives the market, that is the people, to want to pay such different prices to the bond face value? There are many complex reasons which interact with each other. But here is just a list of simplistic reasons to help make sense of it:
- When the general interest rate go up, say Reserve Bank increases interest rate, so banks also increase interest rates. To remain attractive, the bonds which are still not matured, need to attract investors by giving better yield. It can only do this if it sells for a lower price.
- Inflation also drives the interest rate up thus also lowering bond price.
- When the economy is booming, interest rate in general goes up, thus bond yield need to go up to be competitive. This makes bond prices lower. Hence when stock market goes up, bonds go down.
- The reverse is also true. When inflation is low, interest rate low, stock market is down, then bond price goes up.
A real example in the Australian market. Given current market conditions of relatively high interest rate compared to other countries, and a stock market that is not improving, there is a greater chance that the Reserve Bank would decrease interest rates. If this happens, then bond prices should go up. But be wary of holding bonds long term as the inflation risk will slowly reduce the value of bonds.
Conversely, there is talk in the news that the US bond market is reaching a bubble. That may well be true given the historic low interest rate. When the US interest rate starts to increase, then that make break the bond bubble and send prices tumbling down.
This article covers the very basic of bonds. There are various types of bonds like Government Bonds, Corporate Bonds, etc. Please investigate further before investing......
References:
http://finance.yahoo.com/education/bond
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