Bonds 101: Yields, Prices, And Inflation

Tyler Durden's picture

We recently showed 220 years of US Treasury bond yield history but all too often, the average investor is unfortunately unaware of the relationship between bond yields (interesting on a relative-value perspective) and bond prices (the thing that matters for your portfolio's returns). The two measures are inextricably linked obviously (a higher yield implies a lower price and vice versa) but the relationship is not a straight line - it has 'convexity'. The following charts may help understand the upside-downside changes from 'yield' movements, what the Fed is doing to the relationship, and how inflation expectations impact these changes.

Via Goldman Sachs:

Bonds are loans that investors make to governments, municipalities or companies, which typically pay the investors a fixed rate of interest until the bonds mature and the loans are repaid.

The most well-known US government bond is the 10-year US Treasury bond, which matures ten years from the issue date. Right now, investors can purchase a bond for $100 with a yield of about 1.7%, or about $1.70 per year - almost nothing! But there is a bond market that moves daily, so the price of bonds will move depending on interest rates and the economy.

Although investors can simply hold the bond they purchased until maturity and be paid back what they spent in full (plus the interest they've received), they can also sell the bond before maturity. What they get back, however, will depend on interest rates at the time that they sell. If interest rates have risen, then it will be harder to sell their lower-yielding bond, and they will have to sell it for less than they paid for it. If interest rates have declined, then other investors will want to own the bond, and the seller can charge more than they paid for it. So bond holders don't fare well when interest rates rise.

The other thing that bond holders fear is inflation (which typically motivates rate hikes); when consumer prices rise, the interest investors get from bonds is worth less and less in real purchasing power terms.

 

And the yield varies depending on the maturity or length of the investment. The Fed is having a significant impact at various parts of the 'curve'.

 

Charts: Goldman Sachs