Bond Yields Go South As Prices Go North Even Experts Can Get Confused

Bond yields dropped below 7 percent this week for the first time since early 1994.

And folks on Wall Street are just tickled about it.

Why, when a lower yield means an investor receives less? Because bond prices go up.

Confused? Well, even people who think they know these things can trip over their laces when they try to remember why, as the experts say, price and yield move in opposite directions.

So, now that interest rates are falling and bonds are going to be in the news a lot, let’s take a crack at it.

Here’s the first thing to remember: When experts talk about bonds going up or down, they’re talking about bond “prices.” That means, how much you pay to buy a bond.

This is different from talking about bond “yield,” which is a measure of the annual “coupon,” or interest, payment you receive as the bond’s owner.

You might, for instance, pay a price of $1,000 for a 30-year bond with an 8 percent yield. That means you would receive a coupon payment of $80 a year for 30 years, after which you’d get your $1,000 back. (.08 x $1,000=$80.)

Here’s the next thing to remember: When the pros talk about bonds doing well or doing poorly, they’re talking about prices, and they’re talking from the perspective of people “who already own bonds.”

And they figure their audience is people who aren’t expecting to hold their bonds until they mature but hope to sell them sooner - and want the highest price they can get.

Why does this matter?

Well, suppose you paid $1,000 last year for that 30-year bond that yielded 8 percent. You could hold the bond for 30 years (until it matures) and receive $2,400 in coupon payments, then get your $1,000 back. Or you could sell the bond sooner.

If you sell it before maturity, how much will you get?

That depends on a number of factors, such as how long it is until the bond matures or whether the bond’s credit rating has changed.

But the change in yield is the most important factor. Let’s consider a simplified example:

Suppose that interest rates have gone down in the past few months - as they have - and that a new 30-year bond issued today yields 7 percent instead of the 8 percent paid on the bond you bought last year. That means the new bond would pay the buyer a coupon of $70 a year, or $2,100 over the 30 years.

Since your 8 percent bond would pay $300 more than that over 30 years, a buyer would be willing to pay more for your 8 percent bond than for the new 7 percent bond.

Just how much more can be demonstrated - in this simplified example - with some easy math. For the old bond, you take the coupon payment of $80 and divide it by the $1,000 bond price to find that your annual yield is 8 percent.

The coupon remains $80 no matter what happens to interest rates over the next 30 years.

Suppose interest rates drop and new bonds yield 7 percent. You could probably sell your bond so long as the buyer knew he would earn the going rate of 7 percent on his investment.

That means the unchanging $80 coupon payment has to equal 7 percent of the money he or she pays for your old bond.

And that means the buyer would be willing to pay $1,142.86 for your bond. Why? Because $80 equals .07 times $1,142.86.

So here’s what happened: The yield went down from 8 to 7, and the price went up from $1,000 to $1,142.86. “Yield and price went in opposite directions.”

And most important: The one percentage point drop in yield caused a 14 percent increase in the price.

This is why the people who already own bonds like it when interest rates go down. And why they hate it when interest rates go up.