Prices, Rates, and Yields

If you buy a new bond and plan to keep it to maturity, changing prices, interest rates, and yields typically do not affect you, unless the bond is called.

But when you buy or sell an existing bond, the price investors are actually willing to pay for the bond may fluctuate. And the bond's yield, or the expected return on the bond, may also change.

	Factors That Affect Price

	More Factors That Affect Price

	Determining the Exact Price of a Bond

	Yield

	Yield Curve and Maturity Date


	Fixed Income Glossary


	The price investors are willing to pay for a bond is affected largely by prevailing interest rates. Buyers look for a low price.


	The yield on a bond is its annual return, affected in large part by the price the buyer pays for it. Buyers look for high yielding bonds.

Factors That Affect Price

Price is important when you intend to trade bonds with other investors. A bond's price is what investors are willing to pay for an existing bond.

In newspapers and statements you receive, bond prices are provided in terms of percentage of face (par) value.

Example: You are considering buying a corporate bond. It has a face value of $20,000. At three points in time, its price – what investors are willing to pay for it – changes from 97, to 95, to 102.



1. The price is 97, meaning that you can buy the bond for 97% of its face value, or $19,400 ($20,000 x .97). You decide to buy it.

2. The price drops to 95, meaning that if you sell the bond, you can only get $19,000 ($20,000 x .95).

3. The price rises to 102, meaning that if you sell the bond, you can get $20,400 ($20,000 x 1.02).

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Price and Interest Rates Typically Move in Opposite Directions

When prevailing interest rates rise, newly issued bonds typically offer higher yields to keep pace. When that happens, existing bonds with lower coupon rates become less competitive. That's because investors are unlikely to buy an existing bond offering a lower coupon rate unless they can get it at a lower price. Thus higher interest rates mean lower prices for existing bonds.

Conversely, when interest rates fall, an existing bond's coupon rate becomes more appealing to investors, driving the price up.

You own a corporate bond with a coupon rate of 5%. At three points in time, the prevailing interest rate is 5%, 7%, and 3%.

The prevailing interest rate is the same as the bond's coupon rate. The price of the bond is 100, meaning that buyers are willing to pay you the full $20,000 for your bond.

Prevailing interest rates rise to 7%. Buyers can get around 7% on new bonds, so they'll only be willing to buy your bond at a discount. In this example, the price drops to 94, meaning they are willing to pay you $18,800 ($20,000 x .94).

The prevailing interest rate drops to 3%. Buyers can only get 3% on new bonds, so they are willing to pay extra for your bond, because it pays higher interest. In this example, the price rises to 108, meaning they are willing to pay you $21,600 (20,000 x 1.08).


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More Factors That Affect Price

Inflation:

Inflation has the same effect as interest rates. When the inflation rate rises, the price of a bond tends to drop, because the bond may not be paying enough interest to stay ahead of inflation. Remember that a bond's coupon rate is generally unchanged for the life of the bond.

The longer a bond's maturity, the more chance that inflation will rise rapidly at some point and lower the bond's price. That's one reason bonds with a long maturity offer somewhat higher interest rates: they need to do so to attract buyers who otherwise would fear a rising inflation rate. (Another reason is that buyers want a higher interest rate if they are going to tie up their money longer.)

Financial Health of the Issuer:

The financial health of the company or government entity issuing a bond affects the price investors are willing to pay for the bond:


•		If the issuer is financially strong, investors are confident that the issuer will be capable of paying the interest on the bond and pay off the bond at maturity.
•		If the issuer encounters financial problems, or if investors think that it might, then investors may become less confident in the issuer. If so, the price they are willing to pay for the issuer's bonds may drop.


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Determining the Exact Price of a Bond Can Be Difficult

With stock that you own, you know about how much other investors are willing to pay for it, because generally the company's stock is traded throughout the day, and the stock is listed on an exchange. But with bonds, the situation is often not so straightforward.

Prices on Statements May Not Be What You Paid

The price you see on a statement for many fixed-income securities, especially those that are not actively traded, is a price that is derived by industry pricing providers, rather than the last-trade price (as with stocks).

The derived price takes into account factors such as coupon rate, maturity, and quality rating. The price is also based on large trading blocks. But the price may not take into account every factor that can impact the actual price you would be offered if you actually sold the bond.

Derived pricing is used throughout the industry.

Most Bonds Are Not Listed

Most bonds are not listed on an exchange, although there are a few corporate bonds trading on the New York Stock Exchange (NYSE) and American Stock Exchange (ASE). Thus, quoting and pricing are not easy. To receive a quote for the "Bid Price" (the price at which someone will buy your bond), you must receive a quote from a bond trader. At Fidelity, you can call the Bond Desk at 800-544-5372.

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	Price and interest rates: Typically, higher interest rates mean lower prices, and vice versa.

Yield

Yield is the return on an investment, expressed as an annual percentage. For example, a 6% yield means that the investment averages 6% return each year. Thus, when you buy bonds, you generally seek higher yielding bonds, other factors being equal.

There are several ways to calculate yield.

Yield to Maturity

Yield to maturity is often the yield that investors inquire about when considering a bond. Yield to maturity requires a complex calculation. It considers the following factors.


•		Coupon rate - The higher a bond's coupon rate, the higher its yield. That's because each year the bond will pay a higher percentage of its face value as interest.
•		Price - The higher a bond's price, the lower its yield. That's because an investor buying the bond has to pay more for the same return.
•		Years remaining until maturity - Yield to maturity factors in the compound interest you can earn on a bond if you reinvest your interest payments.
•		Difference between face value and price - If you keep a bond to maturity, you receive the bond's face value. The amount you receive may be more or less than the price you paid. Yield to maturity factors in this difference.

A bond has a face value of $20,000. You buy it at 90, meaning that you pay 90% of the face value, or $18,000. It is five years from maturity.

The bond's current yield (see the sidebar) is 6.7% ($1,200 annual interest / $18,000 x 100).

But the bond's yield to maturity in this case is higher. It considers that you can achieve compounding interest by reinvesting the $1,200 you receive each year. It also considers that when the bond matures, you will receive $20,000, which is $2,000 more than what you paid.

The yield to maturity in this example is around 9.25%.


Yield to Call

Yield to call is the yield calculated to the next call date, instead of to maturity, using the same formula.

Yield to Worst

Yield to worst is the worst yield you may experience assuming the issuer does not default. It is the lower of yield to call and yield to maturity.

Two Bonds With the Same Yield May Offer Different Interest Payments

It is possible that two bonds having the same face value and the same yield to maturity nevertheless offer different interest payments. That's because their coupon rates may not be the same.

If you are purchasing a bond primarily for a regular stream of income, then pay attention not only to the yield to maturity, but also to the coupon rate, as that will determine how much money you actually receive each year.

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Yield Curve and Maturity Date

A yield curve is a graph demonstrating the relationship between yield and maturity for a set of similar securities. A number of yield curves are available. A common one that investors consider is the U.S. Treasury yield curve.

The shape of a yield curve can help you decide whether to purchase a long-term or short-term bond. Investors generally expect to receive higher yields on long-term bonds. That's because they expect greater compensation when they loan money for longer periods of time. Also, the longer the maturity, the greater the effect of a change in interest rates on the bond's price.

Ascending Yield Curve

An ascending yield curve (also called a positive or normal yield curve) means that the yield on long-term bonds is higher than the yield on short-term bonds. This is what you expect.

Other yield curves are possible, signifying that long-term yields are not higher than short-term yields. These may make you reconsider whether to purchase a long-term bond.


•		If the issuer is financially strong, investors are confident that the issuer will be capable of paying the interest on the bond and pay off the bond at maturity.
•		If the issuer encounters financial problems, or if investors think that it might, then investors may become less confident in the issuer. If so, the price they are willing to pay for the issuer's bonds may drop.

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Test Yourself

1. You buy a bond with a face value of $30,000. Is this what you will actually pay for it? See the answer.

2. You own a 6% bond and want to sell it in a year. Do you hope that interest rates rise or fall? See the answer.

3. You are considering two corporate bonds, similar in all ways except one is a ten-year bond and the other is a 20-year bond. Which one would you expect to pay the higher interest rate and why? See the answer.

4. You buy a bond and intend to hold it to maturity. Are the bond's changing price and yield a concern to you? See the answer.

5. You sometimes hear that rising bond prices are a good thing and that rising bond yields are also a good thing. How can both be true when they move in opposite directions? See the answer.


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	Yield and price: Whichever way you calculate yield, the higher the price you pay for a bond, the lower the yield, and vice versa.



	Current yield: Current yield is the simplest way to calculate yield:



	For example, if you buy a bond paying $1,200 each year and you pay $20,000 for it, its current yield is 6%.

	While current yield is easy to calculate, it is not as accurate a measure as yield to maturity.