ALL RIGHT, we might as well dive right into the yield and price mess. Since the first bond hit Wall Street, it's the thing that has most confused beginning investors. You've probably heard the mantra at least once before: When yield goes up, price goes down, and vice versa. But if you're like most people, you haven't the faintest clue why.
Well, here goes...
So far, we've discussed bonds as if investors always buy and hold them until they mature. A lot of people do just that, but many others -- including the pros -- buy and sell them on the open market before they reach maturity. Consequently, the price of a given bond can fluctuate -- sometimes wildly. That means it's unlikely you'll ever be able to sell a bond for "par," or 100% of its face value.
We'll explore what drives price changes in the next lecture, but for now, consider what happens when the price goes up or down. As you already know, a bond's periodic coupon and its ultimate payout never change once the bond is issued. Consider a 30-year bond with a face value of $1,000 and a 6% ($60) coupon. If the price falls to $800, you'll still get $60 each year in interest and $1,000 when the bond matures. The same holds true if the bond's market price jumps to $1,200. Obviously, then, the $800 bond is a much better deal -- you're getting the same payout for $400 less.
OK, So What Does 'Yield' Mean?
Yield -- a bondspeak standard -- is a figure that captures this change in value. It's the percentage return your bond investment promises at any given price.
In its most simple incarnation -- known as "current yield" -- it can be expressed with this formula: Yield = Coupon/Price. When you buy a bond for face value, the yield is simply the coupon, or interest rate. But when the price fluctuates, the yield grows or shrinks to compensate in either direction.
Let's look at that 6% bond again. If you were to buy it for $1,000, the current yield would simply be 6% ($60/$1,000). But if the price drops to $800, the yield rises to 7.5%. Why? Because the guaranteed coupon -- $60 -- is now 7.5% of the $800 you paid for the bond ($60/$800). If the price rises to $1,200, the percentage shifts Yield to Maturity
Unfortunately, it gets even more complicated. In the real world, when people talk about yield, they're really talking about another figure, called "yield to maturity." This represents the total return you can expect if you buy a bond at a given price and hold it until it matures.
Yield to maturity includes the fact that the bond you bought for $800 will pay you $1,000 when it's due. It also assumes you reinvest the coupons at the same rate and figures in the compounding effect. If, in the above example, you add that $200 difference and the effects of reinvested coupons, the yield to maturity calculates out to 7.73% -- a significantly better deal than the original coupon of 6%.
Once you've grasped the inverse relationship between price and yield, you're ready to take on the bond market's next puzzler: If yields and prices move in opposite directions, how come both high yields and high prices are considered good things?
The answer depends on your perspective. If you're a bond buyer, high yields are what you're after, because you want to pay $800 for that $1,000 bond. Once you own the bond, however, you're rooting for price. You've already locked in your yield, and if the price rises, it can only be a good thing -- especially if you need cash someday and want to sell the bond to get at it.