Why Bond Prices and Yields Move in Opposite Directions
Bond prices and yields move in opposite directions, which you may find confusing if you're new to bond investing. Bond prices and yields act like a seesaw: when bond yields go up, prices go down, and when bond yields go down, prices go up.
In other words, an upward change in the 10-year Treasury bond's yield from 2.2 percent to 2.6 percent is a sign of negative market conditions, because the bond's interest rate moves up when the market trends down.
Conversely, a downward move in the bond's interest rate from 2.6 percent down to 2.2 percent actually indicates positive market performance. But why does the relationship work this way? The simple answer: there is no free lunch in investing.
From the time bonds are issued until the date that they mature, they trade in the open market, where prices and yields continually change. As a result, yields converge to the point where investors are being paid approximately the same yield for the same level of risk.
This prevents investors from being able to purchase a 10-year U.S. Treasury note with a yield to maturity of 8 percent when another one yields only 3 percent. It works this way for the same reason that a store cannot get its customers to pay $5 for a gallon of milk when the store across the street charges only $3.
The following examples can help you gain a sense of the relationship between prices and yields on bonds.
Interest Rates Go Up
Consider a new corporate bond that becomes available on the market in a given year with a coupon of 4 percent, called Bond A. Prevailing interest rates rise during the next 12 months, and one year later the same company issues a new bond, called Bond B, but this one has a yield of 4.5 percent.
So, why would an investor purchase Bond A with a yield of 4 percent when he or she could buy Bond B with a yield of 4.5 percent? Nobody would do that, so the original price of Bond A now needs to adjust downward to attract buyers. But how far does its price fall?
Here’s how the math works: Bond A has a price of $1,000 with an interest or coupon payment of 4 percent, and its initial yield to maturity is 4 percent. In other words, it pays out $40 of interest each year. Over the course of the following year, the yield on Bond A has moved to 4.5 percent to be competitive with prevailing rates as reflected in the 4.5 percent yield on Bond B.
Since the coupon or interest rate always stays the same, the bond's price must fall to $900 to keep bond A’s yield the same as Bond B. Why? Because of simple math: $40 divided by $900 equates to a 4.5 percent yield. You won't find the relationship this exact in real life, but this simplified example helps provide an illustration of how the process works.
Bond Prices Increase
In this example, the opposite scenario occurs. The same company issues Bond A with a coupon of 4 percent, but this time yields fall. One year later, the company can issue new bond debt at 3.5 percent. What happens to the first issue? In this case, the price of Bond A needs to adjust upward as its yield falls in line with the newer issue.
Again, Bond A came to the market at $1,000 with a coupon of 4 percent, and its initial yield to maturity is 4 percent. The following year, the yield on Bond A has moved to 3.5 percent to match the move in prevailing interest rates, as reflected in the 3.5 percent yield on Bond B.
Since the coupon stays the same, the bond's price must rise to $1,142.75. Due to this increase in price, the bond's yield or interest payment must decline because the $40 coupon divided by $1,142.75 equals 3.5 percent.
Pulling It All Together
Bonds that have already been issued and that continue to trade in the secondary market must continually re-adjust their prices and yields to stay in line with current interest rates. As a result, a decline in prevailing yields means that an investor can benefit from capital appreciation in addition to the yield.
Conversely, rising rates can lead to loss of principal, hurting the value of bonds and bond funds. Investors can find various ways to protect against rising rates in their bond portfolios, such as hedging their investment by also investing in an inverse bond fund.