An investor buying a bond needs to know what return to expect. The most common form of bond yields – annual yield on a fixed income security – is determined by taking the annual coupon payouts and dividing them by the market price of the bond.
If a bond issues quarterly coupon payments of $10 and has a market value of $1,000, the yield would come to $10 * 4 / $1,000 = 4.00%.
A bond must also have sufficient yield in order to attract market demand. For instance, bonds with a credit rating of BB simply will not get any demand on the market, in any economy, if they are offering only a 1% yield. Terms such as “minimum yield” or “required yield” are used to illustrate this concept.
Bond yields are inversely related to a bond’s price. When bond prices rise, yields fall, and vice versa. In the previous example, if a $1,000 bond falls 10% to $900, then its yield would rise to 4.44% ($40/$900) for anyone buying at that price.
Corporate entities and governments issue bonds to raise money. Whenever these bonds are purchased from the seller directly, investors are effectively lending their money. In exchange, the issuer is contractually obligated to pay investors coupons (i.e., interest) on the bonds over the course of their life. The principal of the bond – its par value, commonly $1,000 per bond – is paid upon maturity along with the final coupon payment. Terms can nonetheless vary. Some bonds have some principal paid before the final coupon payment.
Bonds are bought and sold freely on the market. Though some investors choose to hold bonds to maturity, many sell before this date and realize gains or losses. Selling at a gain – that is, the price of the bond increased over the period it was held – effectively increases the yield obtained from the investment.
If one bought a 4% yielding $1,000 bond and one year later had collected a full year of coupon payments ($40, or 4% of $1,000) and seen its price appreciate to $1,050, its yield on the investment would be ($1050 + $40)/$1,000 = 9%.
If, in the second year, its price increased another $50 to $1,100, and collected another year of coupon payments (another $40, so up to $80), its overall return would be equal to ($1,100 + $40)/$1,000 = 14%.
Since yield is annualized, we must take the 14% and take it to the power of 1 over the number of years (2). Thus, its annual yield has been (1 + 14%)^(1/2) = 6.77%. If this individual sold the bond at $1,100, then the yield for the buyer would be $40/$1,100 = 3.64%
The Best Market Environment for Bonds
Fixed income is a highly versatile asset class with different types of instruments that will perform best in different types of economic environments.
For example, prime or high grade sovereign debt will do best in a low growth, low inflation environment. This means that securities that generally do well in a solid growth backdrop, such as stocks and high-yield bonds, are likely to underperform as they are dependent on a level of growth to support their valuations.
Inflation-linked bonds, such as Treasury inflation-linked securities (TIPS), will do well in low growth, high inflation environments.
High-yield (“junk”) bonds, on the other hand, will do best in a high growth, low inflation backdrop. With high-yield securities, better-than-expected economic growth boosts cash flow expectations while lower-than-expected inflation helps to preserve yields in real terms (i.e., higher inflation eats into returns).
Safe bonds also serve as a hedge against a downturn in the stock market. In the 2008 financial crisis, safe bonds, in the form of US Treasuries, were one of the few asset classes to appreciate. In 2008, the US stock market fell 37%. A 40% stocks and 60% long-term US Treasuries portfolio, on the other hand, would have broken even.
Bonds and Interest Rates
Safe bonds typically increase in price during poor economic conditions given central banks will look to lower interest rates to lower borrowing rates across the economy to get credit flowing again. Holding all else equal, this lifts the prices of bonds.
If an investor bought a $1,000 bond at a 3% yield ($30 in coupon payments per bond per year) and the lowering of interest rates brought the new interest rate down to 2%, the new price of the bond would be $1,500 to reflect the $30 in cash flow at a 2% yield ($30/.02 = $1,500).
Higher interest rates, holding all else equal, will raise the price of bonds. For the same $1,000, 3% yield bond, if the raising of interest rates – either via a central bank decision, from inflation, a greater supply of the same security or associated/competing securities entering the market, or from a flight to other assets – brought the interest rate up to 4%, the new price of the bond would be $750 ($30/.04).