How Bond Prices And Yields Work

When we talk about investing, we frequently talk about stocks as they are likely to make up a the bulk of your investment portfolio during the majority of your investing years but bonds can be a helpful part of your investment mix at any age, and it’s important to understand how they work — even if you don’t own many of them right now. This article examines bonds and why we should pay close attention to them these days.

How government bonds work

A bond is simply a vehicle that governments and companies use to borrow money. People buy bonds, and in exchange, receive interest payments. Our country would barely be able to function without bonds.

For the sake of this discussion, let’s focus on government bonds. The U.S. government floats many different securities, but the most common are the 30-year and 10-year Treasury bonds. These bonds pay interest every six months, and the principal of the bond — often referred to as “par value” — is paid in full after 30 or 10 years.

There are also popular securities called Treasury Inflation-Protected Securities (TIPS). The principal of a TIPS can go up or down depending on the movement of the Consumer Price Index.

U.S. Treasuries are very popular worldwide because they are backed by the full faith and credit of the U.S. government, which has historically always repaid its debts.

Yield and price

If you plan to hold onto a bond until it matures, you’ll likely want to take a look at its yield, which is simply a calculation of how much money you’ll make on the investment so, for example, let’s say you have a $10,000 30-year bond with an annual interest rate of 5%. This would mean you’d get $500 per year. This is the bond’s annual yield. It’s also referred to as the “nominal” yield.

There’s another factor that determines how much money you make from a bond, and that is price. Let’s say that the owner of the $10,000 bond above chooses to sell the bond before it matures, for $9,000 — maybe because the issuing company is struggling to stay afloat, or because interest rates are about to see a substantial rise. The buyer of the bond will still continue to get interest payments based on the face value of the bond ($10,000). These interest payments are fixed. Thus, the buyer is receiving the same payments, but because the buyer paid less for the bond, the yield is 5.55%. ($500/$9,000=0.0555, or 5.55%).

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