Bonds are common fixed-income investments that can be used to reduce the volatility of one’s investment portfolio. When I first started buying bonds I had these newbie questions which I didn’t know where to ask.
How’s Bond Price Determined?
When new bonds are issued by the borrower, they are issued at the face value. If you buy them and hold them to maturity you don’t have to worry about bond prices, as you will get your full principal back. However, if you would like to trade an existing bond, its price will be determined by supply and demand, which is ultimately affected by the interest rate, inflation, and credit health of the borrower.
Interest Rate, Bond Yield, and Bond Price?
The interest rate usually refers to the percentage of principal a lender will charge annually on a loan, most of the time the benchmark interest rate is set by the central banks and followed by other banks and financial institutions. Bond yield is the annual percentage profit the investor receives from the bond investment. The yield of new bonds reflects the interest rates at the time the bonds are issued. Eg. the current interest rate is 4%, a new bond issued will have a yield of 4%. If you buy a bond at $100, you will receive $100 x 4% = $4 coupon per year.
However, if the interest rate raises above 4%, the yield of new bonds will be higher too. If you want to sell your 4% yield bonds at this moment, nobody wants to buy them at your face value since they can easily buy new bonds at a higher yield. You have to discount your bond prices to sell them. So your bond prices decrease. That’s why bond yield and bond price are inversely correlated.
Long-Term Bonds vs Short-Term Bonds
I used to think long-term bonds (say 30-year bonds) are less risky than short-term bonds (say 5-year bonds). I was wrong. Long-term bonds are more sensitive to interest rate changes and hence riskier. Long-term bonds have a greater duration than short-term bonds, the probability of interest rate changes during 30 years period is much higher than 5 years period. Also, each interest rate change will result in a higher change in bond price since there are still many coupon payments left which are affected by the interest change. A bigger bond price change is needed to cater to all the affected subsequent payments.
利率指贷款方每年向借款方征收的本金的百分比的费用，通常是国家的中央银行制定给其他银行和金融机构的。债券收益率是债券投资者每年能拿到的收益百分比。债券收益会反应当下的利率。如果当下利率是4%，新的债券就会有4%的收益率。如果你买了一个100块的债券，你会每年获得100 x 4% =4块的收益。
For other topics on financial intelligence, you can find it here https://nickandmoney.com/category/fi/
Follow me on Twitter: https://twitter.com/nickandmoney
nick and money – improve your finances and wellbeing