BBS: The Inverse Relationship Between Bond Prices and Yields
Bonds are debt issued by corporations or governments to borrow money. Corporqate bonds usually have the highest yield but are fully tqaxaable and mostly purchased in retirement qacccounts to defer tqaxation until withdrawn during retirement. Municipal bonds are issued in $1,000 increments and federal and state tax exempt if you live in that state. Municipal bonds do not have federal taxes on interest earned but if you do not live in the state that issued the bond you would pay your state tax rate on the interest it pays. Treasury bonds are issued by the Federal government and are Federally tax free and you pay state taxes on the interest.
When you invest in a bond you are lending them money with their promise to pay interest in semi-annual payments and return your principal to you on the maturity date. In most cases the longer the maturity of the bond the higher interest rate it pays to encourage investors to lock up their capital for longer periods of time. Bonds are typically issued at par or 100 cents on the dollar. Then as they begin to trade the bond price rises if interest rates in general decline after you bought the bond. On the other hand, if interest rates rise after you bought the bond it will decline in value. As the bond nears maturity it’s price will calm down as it gets closer to the redemption date, so if held until maturity bond investors will not lose principal.
This is the inverse relationship between bond yields and interest rate movements. As an example, if you bought a 10 year bond yielding 10% and rates in general decline to where new bonds only yield 9%, your bond would be more valuable and an investor will pay you more than you paid for your 10% bond to earn the higher rate of income.
Conversely, if you bought a 9% ten year bond and interest rates decline to 8%, an investor would pay you more for it to have higher cash flow and you may sell your 9% bond at a premium or higher price than you paid to acquire it.
So when you own bonds you want interest rates to remain stable or decline so your bond will hold it’s value or even appreciate as rates drop.
So when you own bonds you want interest rates to remain stable or decline so your bond will hold it’s value or even appreciate as rates drop.
Bond Ladders , The best way to reduce the price volatility of individual bonds is to purchase them in a ladder format. Given $100,000 bond or fixed income allocation of a portfolio could invest $10,000 in ten bonds due over a decade. For example, the first bond would be due in 3 years, the next bond due in four years, the third bond due in the fifth year until bonds are owned from 3 yeaars to thirteen years to average a solid rqate of return. Think of each bond as a rung in a ladder. So when the 3 year bond matures you would invest the proceeds in the 14th year at the end of your ladder of maturities.
Each year maturing proceeds would leap frog to buy a bond at the end of your maturities. For investors with less capital to allocate tto fixed income can use three types of bond funds. The first would be a short term bond fund with the lowest interest rate. The second fund would be an intermediate bond fund and the third fund would be the long term bond fund paying the highest yield of the three. The problem with bond funds is that they lack permanence and definition. This means the interest rate paid by bond funds can be increased or deqase so they are not locked in like when you buy individual bonds with their own rqate locked in until maturity. Bond funds also lack definition meaning they never mature. In a worse case situation and interests do not decline to the level when you bought your fund it will stay at a loss and not return your money like individual bbonds do when they reach their maturity date.