Why Bond Prices Fall when Yields Rise

A bond is a premium debt security that investors typically associate with security and moderate returns.  After all, buying bonds and holding it for the term is the general idea. However, investors might purchase bond for purposes of trade and speculation – taking advantage of the tradable nature of these financial instruments. Bond trading is the reason that bonds have prices and the reason that these prices fluctuate. While bonds are generally stable and reliable if held until maturity, bond prices change on a daily basis.

• The relationship between yield and prices

The yield represents the return on a bond. At the face value of a bond, the coupon amount represents the original yield multiplied by the face value. The yield has an inverse relationship with the bond price. This means that as bond prices rise, the yield falls and vice versa. At the simplest level, the return on a bond can be calculated by dividing the coupon amount by the bond price.

Current Yield = Coupon Amount/ Bond Price * 100%

The coupon amount represents the nominal amount the bondholder would receive as interest payments at maturity. Therefore, if you bought a $1000 bond for one year at 6%, the coupon amount is $60. The coupon amount remains constant regardless of price fluctuations.

Therefore, if the price drops to $800 the yield is calculated as follows:

Current Yield (7.5%) = Coupon Amount ($60)/ Bond price ($800) * 100%

What if the bond price were to rise? Assume that the bond price rose to $1500.00. The yield would decline:

Yield (4%) = Coupon Amount ($60)/ Bond price ($1500) * 100%

This is the simplest illustration of the inverse relationship. However, investors can also calculate the Adjusted Current Yield and the yield for a zero coupon bond.

• Who benefits?

Whether the yield increases or decreases, someone stands to benefit – if only at the expense of the other. For instance, investor A buys a $500 bond at 10% for a year. The bond price drops to $450. Investor B would love to buy the bond from Investor A at $450, because the yield would be 11.11%. If investor A sells at this price, it would represent a loss of $50. The bond seller benefits if bond prices rise. Any sale above the original price of the bond yields a profit. However, the bond buyer would not appreciate the appreciation in price, since that reduces the yield.

• Causes of price fluctuations

According to investopedia, bond prices are affected by the bond’s face value, coupon amount, maturity, issuers and yield. However, prevailing interest rates also affect the demand for bonds. In a low-interest rate economy, bonds are more attractive, offering guarantees at higher rates in times of uncertainty. This is a bond seller’s market. It becomes a bond buyer’s market when interest rates are higher than what the bond offers. Not many want a bond offering 6% when interest rates are at 8%. The high opportunity cost of investing in bonds make bonds less attractive when interest rates are higher.

Bond prices fall when yields rise because the coupon amount remains constant and the yield is calculated by dividing the coupon amount by the changing bond price. From there, it is simple mathematics; a smaller denominator (bond price) creates a higher-value yield.