When buying a bond, you earn a fixed interest payout regularly until the bond matures. Your principal is locked until maturity. Upon maturity, you will get your initial principal back, and the total interest payout you have received will be your profit. Investing in bonds is one of the lower-risk investment instruments because your principal and interest payout is ‘guaranteed.’ However, this guarantee of your initial principal is only applicable if you hold the bond until maturity. If you need to sell your bond before maturity, you must understand the relationship between bond price vs yield to ensure you are not losing money. The bond price and yield are inversely related, which can be seen from the formula to calculate the bond yield.
Relationship Between Bond Price vs Yield
The bond price is the price you pay to purchase the bond. Bond yield is the interest rate paid to bondholders. For example, if you buy $10,000 worth of a 10-yr government bond yielding 5%, you will get 5% * $10,000 = $500 per year for the next ten years. After maturity, you will get your initial principal of $10,000 back. You will earn $10,000 + 10 * $500 = $15,000.
The formula to calculate bond yield is the annual interest payout divided by the bond value as a percentage. The bond value equals the current bond price. So at the initial offering, the bond value equals your initial principal.
We can see from the formula that the bond yield has an inverse relationship to the bond price. If the bond price falls, the bond yield goes up. If the bond price increases, the bond yield decreases. This is the relationship between bond price vs yield. The question is, how can the bond price go up and down?
Interest rate risk
Imagine you want to sell your bond halfway (at year 5). You were guaranteed a 5% interest rate when you purchased the bond. However, when you want to sell your bond in year 5, the prevailing interest rate is 7%. Why would investors buy your bond yielding 5% in the secondary market when they can buy directly from the government at 7%? Yeah, bad news, no one will buy your bond unless you discount the price. You need to discount enough such that buying your bond yielding just 5% will get investors more profit than buying at par value yielding 7%.
On the flip side, if in year 5, the prevailing interest rate is at 3%, investors would be happy to buy your bond at par value. Why would they buy the bonds at the current market rate of 3% if an option exists in the secondary market with a yield of 5%? That’s the good news. You can increase your price to account for the higher yield.
This is the relationship between interest rate and bond price. When interest rates rise, bond price declines. When interest rates decline, bond price increases. The fluctuation of the bond price from the change in interest rate is called the interest rate risk.
| Bond Price | Bond Yield | |
|---|---|---|
| Interest rates rise | Down | Up |
| Interest rates fall | Up | Down |
How to Avoid Losing Money When Investing in Bonds?
You can invest in the bond market by buying individual bonds directly from the issuers or by buying bond funds. As investors, we need to understand when our investment can be exposed to the abovementioned interest rate risk.
Buying individual bonds directly from the bond issuers
If you buy the bond directly from the issuer, you ideally should hold the bond until maturity. By holding until maturity, you will get your guaranteed principal and interest payouts in full. You don’t have to worry about interest rate risk and volatility because you are guaranteed the principal upon maturity. Holding your bond until maturity means not being exposed to bond price fluctuation.
However, if you want to sell your bond at any time before maturity, you will be exposed to the interest rate risk. Generally, investors who invest in bonds are in for stability and guaranteed payouts, so worrying about price fluctuation is not preferable. This is why we always recommend investors ‘buy and hold’ the bonds until maturity to avoid the interest rate risk.
Buying bond funds
When buying bond funds, you hold a basket of bonds from various issuers and maturities. You don’t have the choice to buy and hold until maturity because you don’t hold the bonds directly. In this case, you will be exposed to the interest rate risk. If you buy a bond fund yielding 5%, but then the interest rate rises to 7%.. yeah, you guessed correctly, no one wants to purchase your bond fund, and you cannot sell it at the same price you acquired it. You need to discount it. And vice versa when the interest rate drops. You are fully exposed to interest rate fluctuation.
Sophisticated investors use this bond price vs yield inverse relationship to their advantage by acquiring bond funds when interest rates are high. They hold until interest rates revert down again. As a result, the bond fund price will rise, thus providing investors with a capital gain. This is in addition to the regular payouts received by the investors while holding the funds.
Summary
Bond price vs yield has an inverse relationship. When the yield declines, the price rises, and when the yield increases, the price declines. Furthermore, the interest rate has an inverse relationship with the bond price. If interest rates go up, bond price declines. If interest rates go down, bond price increases.
Investors who directly hold the bond until maturity will not be exposed to this bond price dynamic because their principal is guaranteed upon maturity. However, if they need to sell the bond before maturity, the price may fluctuate following the prevailing interest rate. As a result, investors may be exposed to a capital gain or loss when selling.
Investors in bond funds are exposed to this bond price fluctuation. Investors must be aware of and be comfortable with this risk before investing in bond funds.
