Interest Rates and Yield
For many new investors, the concepts of interest rates and yield vs. bond prices can be confusing. This is due to the fact that these numbers move in opposite directions.
For many, however, actually understanding this concept requires a bit more information in order to make sure investments are handled in the best ways possible.
Interest rates apply to all loans and are a portion of the overall amount. This rate is essentially what the borrower will pay in order to borrow the money.
The rate of interest varies based on a number of factors, including the borrower’s creditworthiness, the length of the loan, and the supply and demand for loans in the market.
When it comes to bonds, the interest rates are fixed at the time of purchase.
Bond yields are the interest which the bond is expected to pay on the borrowed money.
There are several different types of bond yields:
- Coupon or Nominal Yield – This is set when the bond is issued and is a fixed percentage of the overall value.
- Current Yield – Current yields are the result of the coupon payment divided by the bond’s current price, which provides insight into how the market price relates to the coupon payment.
- Yield to Maturity – This yield reflects the total value of the interest paid at maturity. This amount includes any potential capital gains or losses that will be redeemed.
- Yield to Call – If a bond is issued with a call feature, it means that the issuer can redeem the bond earlier than the maturity date. This yield considers the potential losses or gains at that date rather than maturity.
Another important part of understanding yields is the credit spread.
Generally, this term is used to describe the difference in yield that results when two bonds have similar maturity but have differing credit quality.
In these instances, the entity with the lower credit quality will have to have a higher return than that of another company with a higher credit quality.
Bond Yield/Interest Rates vs. Bond Price
Understanding the factors that determine bond yields is important, as it will help you better understand how fluctuations in interest rates affect overall returns on investments.
Any bonds that are traded on secondary markets will be affected by changes in interest rates, which will require readjustment of the bond pricing and yields.
If interest rates and/or credit spreads rise , the bond’ s yield also rises, and the market price of the bond drops. Conversely, declining interest rates and/or credit spread lower bond’ s yield and increase the value of the bond.