Bond Prices and Yields
Bond prices and yields have an inverse relationship. When prices go up, yields go down—and vice versa. This is crucial to understand.
The Inverse Relationship
If you buy a $1,000 bond with a 5% coupon, you receive $50/year. If interest rates rise and new bonds offer 6%, your 5% bond becomes less attractive. To sell it, you'd have to lower the price. If you sell for $900, the buyer still gets $50/year, but their yield is now 5.56% ($50 ÷ $900).
Why This Matters
When the Federal Reserve raises interest rates, existing bond prices typically fall. When rates are cut, existing bond prices rise. This affects bond fund values and is why bonds are considered interest rate-sensitive investments.
Interest Rates Rise
- New bonds offer higher yields
- Existing bonds become less valuable
- Bond prices fall
Interest Rates Fall
- New bonds offer lower yields
- Existing bonds become more valuable
- Bond prices rise
Current Yield vs. Yield to Maturity
Current yield is simply the annual interest divided by the current price. Yield to maturity (YTM) factors in any capital gain or loss if you hold until maturity. YTM is the more accurate measure of your total return.
- Bond prices and yields move in opposite directions
- Rising interest rates cause existing bond prices to fall
- Yield to maturity is the total return if held until the bond matures
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