The bond market has been a topic of focus recently given the fallout of Silicon Valley Bank (SVB) and Signature Bank.
There’s an inverse relationship between bond prices and yields. This means that when bond prices go up, yields go down, and vice versa.
To understand this relationship, it’s helpful to know that a bond is essentially a loan that an investor makes to a company or government. When you buy a bond, you’re essentially lending money to the issuer in exchange for interest payments (known as the bond’s “yield”) and a promise to repay the loan (known as the bond’s “face value” or “par value”) at a later date.
Example
Let’s say that you buy a bond for $1,000 with a yield of 3%. This means that you will receive $30 in interest payments each year for the life of the bond (usually several years). However, let’s say that interest rates in the broader economy start to rise, and new bonds with similar risk profiles are now offering yields of 4%. This means that your 3% bond is now less attractive to potential buyers, since they can get a better return on their investment elsewhere.
As a result, the price of your bond may start to fall, since there are fewer buyers willing to pay $1,000 for a bond that is only offering a 3% yield. In order to make the bond more attractive to potential buyers, the yield on your bond may need to increase to match the yields being offered by new bonds. This means that the bond’s price will fall until its yield matches the market rate.
Conversely, if interest rates fall and new bonds with similar risk profiles are now offering yields of 2%, your 3% bond becomes more attractive to potential buyers. This means that the price of your bond may start to rise, since there are more buyers willing to pay $1,000 for a bond that is offering a higher yield than new bonds. In order to keep the bond’s yield in line with the market rate, the price of the bond will rise until its yield matches the market rate.