Trade Bonds

Bond yields and bond prices are inversely correlated. When the yield goes down, the price goes up, and when the price goes down, the yield goes up. This may seem confusing at first, but it makes more sense when you consider the supply and demand characteristics of bond investing.

Investors flock to bonds in uncertain times because they tend to offer a higher yield than holding cash, and if the issuer has a high credit rating, bonds can be considered almost as safe as cash. However, when demand for bonds exceeds supply (i.e., everyone wants to invest in bonds), the yield drops because the issuer has no trouble raising cash in such circumstances.

Conversely, when few people want to invest in bonds, perhaps because other areas of the market, like stocks, are performing well and look more attractive, the only way to attract capital to the bond market is by raising the yield to make it appealing to investors.

This is why, when bond yields are rising, the bond market is thought to be in trouble, and when bond yields are falling, the bond market is thought to be in good health. Of course, this can sometimes be taken to extremes.

The prevailing interest rates at the time of investment are a key driver of bond prices and yields. Keep in mind that bond issuers are always competing with the yields offered in the broader economy.

This dynamic becomes more complex when interest rates change. For example, say you invested in a bond that yields 2%, but halfway to its maturity, the interest rate offered by the banking system rises from 1.5% to 2%.

The issuer of the bond you purchased must now compete with the higher interest rate offered by the banking sector and will issue new bonds with a higher yield. This puts holders of the original 2% yielding bond at a disadvantage, as they effectively paid the same price for less yield. Since the coupon is fixed, the only way to address this imbalance is for the price of the first bond to drop until its yield matches that of the newer, higher-yielding bond.

The same happens when interest rates fall. If wider interest rates decline, newer bonds will be issued with a lower interest rate. Since coupons are fixed, the price of the older, higher-yielding bonds will rise to bring their yield in line with the newer, lower-yielding bonds.