One of the challenges that new investors face in the bonds market is understanding the relationship between bond prices and yields. This is because the two have an opposite correlation. When bond prices are going down, the bond yields are moving up and when the bond prices are moving up, the yields are moving down. This means that a fall in bond’s interest rates indicates a positive market performance while a percentage gain in the bond’s yield indicates a negative market condition. The simple reason for this occurrence is the changes in investment in the market.
Bonds are usually released to the open market for investors to take action and they do this immediately the bonds are in play. All bonds markets are typically the same. The process that you find when you buy government bonds UK market is typically the same as other markets. When the bonds are in the market, prices continually change. The risk factors in the market are considered when calculating the yields. In general, bond yields converge and it makes no sense to invest in an asset that has a higher maturity interest rate when there are options with lower interest rates. In order to understand the relationship between prices and yields on bonds though, it is important to look at each market scenario.
Rising interest rates
To give an illustration of what happens when the interest rates of a bond are rising, consider a situation where a corporate bond has been issued in the market at a rate of 3 percent. This bond will stay in the market for a while. Over the course of say, 6 months, the bond’s interest has appreciated by 0.5 percent. Now the bond has a rate of 3.5 percent. If there is a corporate bond issued at this time with a lower rate of say, 3 percent, then the original bond will not be as attractive as the new bond with a lower interest rate. Because of a fall in demand, the original bond will need to adjust its interest rates downwards.
It is also important to understand how much the original bond’s interest would need to fall. If the original bond is bond x’ and it has a price of $500, while its original interest rate is 5%; it would pay $25 annually. But when it moves to 3.5 percent over the following year, its yield falls since the total coupon and interest rates must compound to the same amount.
When bond prices rise
As stated earlier, there is an opposite correlation between bond prices and yields. To illustrate what happens when bond prices rise, let us take the example of the bond x’, issued by a corporate as discussed in the previous paragraphs. When the bond is issued with a coupon of 3 percent but the yields fall, it is the price of the bond that will need to adjust upwards a year later. This will be the case if the company issues a new bond debt of 2.5 percent. The upward adjustment will thus be necessary for the yield to be in agreement with the new issue.
This example is a simplified version of what typically happens in the markets. The general rule of opposite correlation sticks regardless of the prices of the bonds. As long as the bond is issued, the yield and price will have an opposing correlation because of the market forces. The pressure that investors put in the market always ensures that investment occurs when there is a favorable option.
In short, the time difference between the issuance of bonds is essential. Every new bond that is issued forces the adjustment of prices for other bonds that have already been trading in the market for a while. The issuance of new bonds thus creates a scenario where two markets are operating in one. The older generation bonds become part of the secondary market while the new bonds become part of the primary market. For investors, a decline in the prevailing yields means that gains will be made from capital appreciation. On the other hand, rising rates result in the loss of principal and this can negatively affect the value of bonds. Investors thus have the choice of choosing their investments carefully.