Understanding the price fluctuation of bonds is probably one of the most confusing things for investors.
In fact, many new investors are surprised to learn that a bond’s price changes on a daily basis, just like that of any other publicly-traded security. Some investors hold their bonds to maturity.
It’s true that if you do this you’re guaranteed to get your principal back; however, a bond does not have to be held to maturity.
At any time, a bond can be sold in the open market, where the price can fluctuate — sometimes dramatically.
We’ll get to how price changes in a bit. First, we need to introduce the concept of yield.
Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.
Let’s demonstrate this with an example. If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10 per cent ($100/$1,000). Pretty simple stuff. But if the price goes down to $800, then the yield goes up to 12.5 per cent. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33 per cent ($100/$1,200).
So what is yield to maturity? Of course, these matters are always more complicated in real life.
When bond investors refer to yield, they are usually referring to yield to maturity (YTM).
YTM is a more advanced yield calculation that shows the total return you will receive if you hold the bond to maturity.
It equals all the interest payments you will receive (and assumes that you will reinvest the interest payment at the same rate as the current yield on the bond) plus any gain (if you purchased at a discount) or loss (if you purchased at a premium).
So how do we put this all together? The relationship of yield to price can be summarized as follows: when price goes up, yield goes down and vice versa.
Technically, you’d say the bond’s price and its yield are inversely related.
Here’s a commonly asked question: How can high yields and high prices both be good when they can’t happen at the same time? The answer depends on your point of view.
If you are a bond buyer, you want high yields.
A buyer wants to pay $800 for the $1,000 bond, which gives the bond a high yield of 12.5 per cent. On the other hand, if you already own a bond, you’ve locked in your interest rate, so you hope the price of the bond goes up. This way you can cash out by selling your bond in the future.
Bonds are an integral part of a well diversified portfolio. Bonds are rated by rating agencies and they are available by issuers like federal and provincial governments, municipalities and corporations.
Remember to always consult your advisor before taking any action.
Stuart Kirk is an Investment Funds Advisor with Manulife Securities Investment Services Inc and a Retirement Planning Specialist with Precision Wealth Management Inc. The opinions expressed are those of the author and may not necessarily reflect those of Manulife Securities Investment Services Inc or Precision Wealth Management Inc. For comments or questions Stuart can be reached at email@example.com or 250-954-0247.