In just about any news article about bond trading, there’s one statement that is almost guaranteed to appear. Here are some recent examples from The Wall Street Journal:

“Yields and prices move in opposite directions” (February 29, 2008). “Prices and yields move in opposite directions” (April 8, 2008). “Bond yields move in the opposite direction of prices ...” (April 11, 2008).

Why is this seemingly confusing statement so widely used? It contains a key concept that can help investors understand how the bond market works.

The price/yield relationship is rooted in the secondary bond market, where bonds may trade at a premium or discount of the par (or face) value.

Let’s assume that Investor A bought a bond priced at $1,000, paying a hypothetical 5% coupon rate. Investor A’s current yield (the return for holding the bond for one year) is 5%.

Now let’s say that, after one year, Investor A decided to sell the bond to Investor B. Because interest rates on new bonds were higher than 5% at the time of the sale, Investor B was willing to pay only $950 for the bond. As you can see in the accompanying table, Investor B’s current yield is higher because he was able to buy the same 5% coupon for a lower price.

The principal value of bonds may fluctuate with market conditions. Bonds redeemed prior to maturity may be worth more or less than their original cost. Investments seeking to achieve higher yields also involve a higher degree of risk.

Understanding the bond price/yield concept can help an investor decide whether to trade or hold an existing bond based on current interest-rate conditions.

This material was written and prepared by Emerald Publications.
© 2008 Emerald Publications