Bond Yields, Maturity, and Interest Rate
What makes the price of bonds goes up and down — and is it bad?
Bonds are known for being a safe investment, but many big institutions’ failures in 2023 are attributed to bonds. What happened? Why are these safe assets suddenly an integral part of many institutional crises? This article will look into the components of a bond, right from the moment you acquire it, up to the point that it’s no longer yours — what affects bond prices, how interest rates affect bonds and more.
Before we go any further if you have a more general question on bonds, like what types of bonds are there, and the pros and cons of going for bonds, feel free to check out our writeups here: Investing in Bonds for Beginners.
What are the main components of a bond?
The nominal value here refers to the actual value of the bond — or the value that you will be able to redeem later once the bond reaches maturity. For example, if you acquired a bond from the U.S. Government for $1,000 that will reach maturity in 5 years, regardless of whatever happens, the nominal value of that bond will be $1,000.
So, once the maturity date is reached, just go to whoever it is that issued the bond to you, give them the bond paper and they will give you your $1,000 back.
If (in a hypothetical scenario) the economy went into a spiral of chaos and the U.S. Government decided to default on its bond, the nominal value is still there, it’s just that you can’t claim it.
Coupon (bond’s interest rate)
Another thing that will be stated on your bond is the coupon rate, which is the interest rate that you will receive as the holder of the bond. This interest rate will stay the same until the bond matures.
For example, if your bond states you will receive 5% per annum (p/a), it means that on top of that $1,000 you are going to redeem back once the bond matures, you will also be entitled to 5% of the bond’s nominal value every year until the bond matures. So, if the period is 5 years, you are looking at $250 in interest.
If you keep your bond until the end, in total you’d receive $1,250 in lieu of the $1,000 you just gave 5 years ago.
The maturity date is the date when the bond that you hold will be redeemable from whoever issued it. For example, if you bought a bond in the year 2023 and it says that the maturity date is 2033, it means that the maturity date for your bond is 10 years — which is when you’ll be able to redeem your money again.
The maturity date can even extend to decades, so be sure to know what you’re signing in for.
Market price here refers to the current price of the bond if you want to sell it. A bond is just a piece of paper that gives whoever holds it the ability to claim the amount later (and to get the interest payment) — so, this piece of paper can be given away, sold, and traded.
For example, you bought a bond for $1,000 in the year 2019. Say, you need quick cash and you have to sell that bond, despite the nominal value saying it’s $1,000, sometimes you’ll get less because people aren’t interested in the interest rate, or it could be worth more if the interest rate is good — we’ll touch on this more later.
Bond yield is somewhat of a calculation of how much you will make from the bond based on the market price of the bond. It is used by investors to see if the bond is worth their money or not.
The formula for bond yield is:
Yield = Coupon/Market price * 100
So, for example, if:
Coupon rate = 5
Market price = 900
Yield = 5/900 * 100
Yield = 0.56%
Investors would then see if this 0.56% is a good yield compared to yields of other bonds in the market or not.
Fun fact, the U.S. 10-year bond yields have been hovering around 2% to more than 3% from the year 2022, so a 0.56% yield may not look as tempting.
How does a bond work?
It’s really simple, you could even say it’s almost as simple as one-two-three! First, you go to the bond issuer, and you purchase the bond. Say, it’s a 10-year $1,000 bond, so you pay the amount, and you get the note.
You now are a proud owner of a bond note of $1,000 with a coupon of 5% p/a, which will mature in 10 years’ time. Congratulations!
Wait for it.
The next thing that will happen is that you will now receive the interest payment every year. So, your bond is $1,000 with a coupon of 5% p/a. That means every year you’re going to get around $50. If you wait until 10 years, that’s a $500 in interest.
The last and final step is once the bond has reached its maturity date, you can now redeem it to get back the principal amount that you gave. So now, it’s time to say hello again to the $1,000 that you parted with while you’ve also made $500 over the years.
Alternatively, if you think life is an inevitable march towards doom, and you want to make use of the cash there and then, you can sell the bond to other people.
The price may not be the same anymore — say you bought the bond at $1,000, but now the price could be $800 for all we know. Also, take note that once you sell it, you are no longer entitled to the interest payment. You get to keep what you made over the years, but the rest is the buyer’s — including the $1,000.
How do Interest Rates Affect Bonds?
This is a question that many have been asking — here’s how. The coupon rate for new bonds will be dependent on the interest rate that is set by the central banks.
Let’s take an example — you bought a 10-year bond in the year 2022 for $1,000 with a coupon rate of 5% p/a — that’s $500 in interest, cool!
In the year 2023, however, the central bank raised interest rates so that now all new $1,000 bonds will have an interest rate of 8% p/a. Now everyone else is looking at $800 in interest.
What happens to the bond that you bought in 2022? Well, if you decide to keep it, you will still get the $500 in interest, and the $1,000 that you paid for in the first place.
However, if you want to sell it before the maturity date for quick cash, people now will have options — do they buy a $1,000 bond from you and make only 5% p/a, or do they buy a $1,000 bond from someone else and make 8% interest p/a?
This is the situation where people say the market price of bonds will fall if interest rates hike up, because people essentially have better options, and whoever that holds bonds before the hike will have to sell them at a lower price to get their attention. Now the bond that you bought for $1,000 may be sold at less.
Alternatively, when the bond price falls, the bond yield increases. Logically, it’s like buying 1kg of lettuce. Regardless of the price, you are still getting 1kg of lettuce. So, if there’s a place that sells cheaper, you’ll gain more lettuce per the money you spent.
If you want to show people how much of a nerd, you are — we can go back to the yield formula:
Yield = Coupon/Market price * 100
So, the lower the market price of a bond is, the higher the yield will be.
- When you purchase bonds, you will essentially receive back your money with interest.
- Bond is less risky, but there are situations where bond issuer fails to pay.
- Nominal price of a bond is the amount that you can get when you redeem the bond later, while the market price is how much people are willing to buy it for if you want to sell the bond prior to maturity.
- When the interest rate rises, the newly issued bonds will provide accordingly higher interest rates, making old bonds less desirable to buyers.
- Bond market price will fall if the interest rate goes up.
- Bond yield will rise if the interest rate goes up.
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