Bonds Part 1: The Difference Between Price and Yield

The way the media reports day to day bond market activity can be confusing. The reason is that they can either choose to focus on price or yield to convey what they did that day. One reporter may say “prices on bonds rose today” and another may say “yields on bonds fell today” and they are saying the same thing.

My favorite way to explain these terms is to use an analogy of CDs because most of us are familiar with them and we are also aware of how CD rates change all the time. Imagine for a moment that you could buy and sell CDs in the middle of their term to other people in the bank lobby. Let’s say last year you bought a three year $100 CD at 5% (so you still have two more years to go enjoying the rate). And let’s say that I come into the bank and the banker tells me that the rate is now 2%. So I turn to you and offer to buy your CD from you because I want to buy your good rate. You would say, “Okay, but I’m not going to sell it to you for $100 because I own a valuable interest rate.” So maybe you’d sell it to me for $106 or something. What’s happen is that because the rate environment changed, the value (or selling price) has gone up and you are selling the CD to me at a premium. However, had you kept your CD to maturity you would have simply gotten your $100 (or what is also called it’s par value) back when it matured two years later. Part of what drives the selling price is how much time you have left on your term. If you only had one more month on it and it meant I’d only enjoy the higher rate for a short while, I wouldn’t pay $106, but maybe I’d pay $100.25. The closer you get to maturity, the price will move toward par value.

But, just the opposite could have happened. Let’s say that last year you bought a three year $100 CD at 2% and that now a year later I walk in and the bank offers me a 5% rate. You need to get the money out of your CD and you ask me if I’ll buy it. I tell you, “Why would I buy your 2% rate when the bank will give me 5%?” So then what you do is sell the CD to me at a discount for maybe $94. In which case over the past year you made 2% in interest (or what is $2 in this case), but then lost $6 (or what is 6% in this case) when you went to sell it (resulting in an overall loss of $4). Now, had you kept the CD to maturity, the bank would have given you your $100 back.

So, that being said, the difference between price and yield is that yield is like the interest rate in my CD analogy. Price is the day to day movement of how much that bond could sell for based on various factors. So when you hear the media say that interest rates fell on Treasuries you can assume that people who already held those bonds saw the value of their bonds go up (because they now own a more valuable yield). Conversely, if yields go up, bond investors would lose some value in their bonds.

Taking this out a little further, the yield on Treasury bonds has not be lower in more than 50 years (consistent record keeping started in 1962). Right now, if you were to buy a 10 year Treasury bond you’d be getting less than 2%. If we’re at record lows right now and we know that the rate doesn’t have much room to go any lower, what are the odds that in the next 10 years rates are going to be higher than they are? If rates were to go back up, based on what you know now, what is this going to do to the value/price of bonds paying a 2% rate? I believe a lot of people out there panicked out of stocks and went into Treasuries with the mindset, “a 2% yield is better than the losses I’ve been having”. What I wonder is how much would rates have to go up, to completely wipe out their last few years of interest through a price decline? Who knows, but I don’t think it would take much because they have been getting much in yield. It could end up being an “out of the frying pan and into the fire scenario”.

All of this circles back around to the absolute necessity to have a financial plan that if properly administered can guide investors away from the issues of their day. Following the masses and their herd instincts can lead to jumping out of the frying pan every few years. When it comes to understanding price and yield, keep in mind that they move in opposite directions. If yields go up, in means that prices went down – and vice versa.

 

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