bond prices & their yields
Post on 16-Apr-2017
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Understanding the Inverse Relationship between Bond Prices
& Yields– By Prof. Simply Simple TM
Why do bond yields go up when bond prices go
down?
You might have come across a set rule which states, ‘When bond prices goes
down, bond yield goes up & vice versa’.
This rule is then simply memorized and never
questioned.
Memorizing without questioning makes concepts
dull and boring but understanding, on the other hand, makes concepts come
alive.
I am sure you will agree that when the seller of a
good sells at a lower cost, he makes a lower profit. However, in the
same deal the purchaser of the good makes a gain
due to the attractive price of purchase.
Hence when a seller of a bond sells it at a reduced price, while he loses, the buyer of the bond gains
from the transaction.
Thus the loss for the seller is the fall in price while the gain for the buyer is the benefit of
higher yields.
Now let’s understand with a simple example.
Let’s assume that Ravi has a corporate bond of Rs 100 which is to give him 10%
returns per annum.
In other words, the company would pay him Rs. 110 at the end of the year for the Rs 100 loan that Ravi has given to the
corporate.
The 10% yield thus translates to Rs 10 of profits for Ravi.
Now let’s assume that Ravi has an emergency and needs his money back. For this he
goes to the market and finds his friend John. John realizes
that Ravi needs money urgently. So he offers Ravi to buy his bond for Rs 90. Ravi, agrees to the offer and sells
the corporate bond for Rs 90.
At the end of the year John receives the Rs 110 from
the corporate.Thus John earns Rs. 20
from his investment of Rs 90 which he makes when
he buys the corporate bond from Ravi.
Thus, John’s % return (which is popularly known as the yield) works out to:
{20/90}x100 = 22.2%
Thus while Ravi suffered a loss by selling his corporate bond at a lower price of Rs 90 instead of his purchase
price of Rs 100translated into a gain for
John in terms of higher yield which for him went up from
10% to 22.22%.
Having understood the concept, it will not be
difficult for you to appreciate the inverse relationship between the price of the bond and its yield (for the
buyer of the bond). i.e. A bond’s yield goes up when its price goes down
and conversely the yield of the bond comes down when the price of the bond goes
up.
I hope you now have a better conceptual understanding of the inverse relationship between the price and yield of a “bond” and that you won’t have to blindly
memorize.
I will be glad to receive your feedback on this lesson to
understand if there any gaps.
Also if you wish to demystify any other concepts, please
write to me about them.
Please send your feedback to professor@tataamc.com
The views expressed in these lessons are for information purposes only and do not construe to be of any
investment, legal or taxation advice. They are not indicative of future market trends, nor is Tata Asset Management Ltd. attempting to predict the same.
Reprinting any part of this presentation will be at your own risk and Tata Asset Management Ltd. will not be
liable for the consequences of any such action.
Disclaimer
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