Across the world, the bond market is the largest securities market which provides investors with limitless options to invest and grow their money as well as diversify their portfolios.
Businessmen, financial market traders, politicians and investors keep constant watch over bond markets as they sway north and south. But before we delve into the complexities of this ginormous all-powerful market, there are two key parameters that we must understand and bear in mind – the price and the yield of the bond- which convey lots of information, individually and in the aggregate.
That is because ultimately the value of any bond that is trading in the financial markets is derived from its price and yield. This article explains the critical relationship between bond price and bond yield.
Table of Contents
What Is Bond Yield?
For any corporate or government bond, yield indicates the return on invested capital in percentage terms. It relates the bond’s rupee price to its cash flows. These cash flows consist of i) coupon payments and ii) the return of principal when the bond matures.
The yield you can earn on a bond depends on whether you purchased the bond for more than its face value (at a premium) or less than its face value (at a discount). Higher yields, which are common with longer-maturity bonds, mean that investors are owed larger interest payments. They also indicate greater risk in that bond. Thus, the riskier an investment, the more yield investors demand.
Suppose you buy a 10-year bond of Rs.10,000 that pays a yearly interest of Rs. 500. Its coupon rate, which is also known as the coupon yield, is calculated as:
Coupon rate = Annual interest rate (coupon payment)
Bond Face Value
The coupon rate is the simplest way to calculate yield since it only depends on the bond’s face value and annual coupon payment rate.
In our example, the bond’s face value is Rs.10,000, and it pays out a yearly interest of Rs.500. Therefore, its coupon rate or coupon yield is calculated as (500/10,000) = 5%.
This rate is established when the bond is issued and does not change during its lifespan. Thus, for your Rs.10,000 investment, you will earn returns at the coupon rate of 5% during the entire 10-year maturity period of the bond.
But what if you want to sell your bond before maturity? Here’s where the current yield comes in.
Unlike the coupon yield, which will always remain the same, the current yield changes depending on the bond’s current market price and its coupon (interest) payment.
Current yield = Annual coupon payment
Current Market Price
If you buy a new bond at par and hold it until it matures, your current yield at maturity will be the same as the coupon yield. However, if you purchase the bond from the secondary market, your current yield will not match the coupon yield but will depend on the bond’s price.
For the same example above, suppose the bond price in the secondary market falls to Rs.6,000. If the coupon rate remains the same (5%), your current yield will now “fall” to 8.33%.
These calculations notwithstanding, the current yield and the coupon rate are incomplete calculations for a bond’s yield. This is because they do not consider the time value of money or other factors like the bond’s maturity value or payment frequency. Here’s where other calculations like yield to maturity (YTM), yield to call (YTC), and yield to worst (YTW) come in.
What Is Bond Price?
A bond’s price is the sum of the present value of each of its cashflows. Cashflows are all present-valued using the same discount factor, aka yield. The price depends on how much you will earn from the bond over a certain time period. To calculate the price, you will have to compare today’s rates (the discount rate) on similar bonds, as well as the present value of remaining payments and the bond’s face value.
When you buy a bond at issuance, its price is the same as its face value. Moreover, its yield will match its coupon rate. So, if the bond pays 5% interest for 10 years, then that’s exactly what you will get for the next 10 years, assuming you hold the bond till maturity. When the bond matures, you will get back its face value.
The bond’s market value may change over its 10-year lifespan. However, the value is of no interest to you – unless you decide to sell it. If you do, you will have to consider the bond’s market price and annual coupon payment to calculate your current yield (see the previous section).
If a bond is trading at a premium on the secondary market, its price has gone up since it was issued, which means it is now more expensive to buy. On the other hand, trading at a discount means that the price has declined, so it is cheaper to buy now than when it was first issued.
The Inverse Relationship Between Bond Yield and Price
When a bond is issued at par value, its yield equals the coupon rate. The yield is its rate of return considering changes in price and after discounting the bond’s cashflows at prevailing market rates.
Bond yield and price are inversely related. Thus, as the price goes up, the yield decreases, and vice versa. This relationship exists because the bond’s coupon rate is fixed, which requires the price in secondary markets to change to align with prevailing interest rates in the market.
Suppose you buy a bond with a face value of Rs.1,000, a maturity period of five years, and a 10% annual coupon rate. In this case, your coupon yield will be Rs.100, which you will earn as annual interest payouts.
What happens if you want to sell the bond and interest rates have increased too, say, 12%? In this scenario, potential investors will not buy your bond, instead buying new bonds that offer a higher interest rate. This is because they can earn a coupon yield of Rs.120 on the new bond instead of just Rs.100 on your “outdated” bond.
To sell your Rs.1,000 bond, you will have to lower its price (sell it at a discount), so its coupon payments and maturity value equal a yield of 12%. Lowering its price (downward adjustment) increases its yield and makes it an attractive investment proposition for a buyer.
The same logic applies if interest rates fall, but in the opposite direction. Falling interest rates will lead to a rise in your bond’s price because its coupon payment now becomes more attractive than other new bonds. In other words, your bond adjusts upwards to match its yield to the yield of a new bond with a lower coupon rate. The more the bond’s interest rate falls (rises), the more its price will rise (falls).
Take Advantage of India’s Thriving Bond Market with Aspero
Understanding bond yields and the relationship between yield and price is crucial to making the most of India’s bond market. It’s also vital to leverage technology to access bond investment options, calculate accurate risk-reward ratios, perform due diligence of new issuers, and manage your bond investment portfolio. Such technology powers the Aspero Invest platform.
With Aspero, you get instant access to a diverse set of investment options from a range of industries and across the rating spectrum from AA+ to BBB. This unified investment platform is built for wealth partners, HNIs, family offices, and bond issuers. If you are an investor, Aspero will help you access and execute the correct investment choices.
Whether you want to invest in market-linked debentures, non-convertible debentures or tax-free bonds or acquire commercial papers from different sectors, Aspero will guide you at every step. And if you are an issuer, the platform will enable you to raise capital in a hassle-free manner.
Aspero is designed to ensure seamless execution of the whole trade for multiple clients at once. With an eclectic risk-reward ratio, quality execution at speed, and uncompromising data security – Aspero brings all these world-class capabilities into India’s fixed-income investment landscape.
Click here to get started with Aspero for free.
