How do bond prices and yields work? Can I benefit from buying bonds now, instead of stocks?
Dubai: When we talk about investment, we often talk about equities. Stocks are likely to make up the bulk of your investment portfolio for the majority of your investment years.
Bonds, which tend to be less risky but also less rewarding, are more important as you approach retirement.
However, bonds can be a useful part of your investment mix at any age, and it’s important to understand how they work, even if you don’t own a lot at the moment.
Let’s take a look at obligations and why we should pay special attention to them these days.
How government bonds work
A bond is simply a vehicle that governments and businesses use to borrow money. People buy bonds and in return receive interest. Our country could hardly function without ties.
For the sake of this discussion, let’s focus on government bonds. Globally, almost all governments issue many different types of securities, but the most common are 30-year and 10-year treasury bills.
These bonds pay interest every six months, and the principal amount of the bond – often called the initial amount or âface valueâ – is paid in full after 30 or 10 years.
There are also popular titles called Inflation Protected Securities. The principal amount of inflation-protected securities may rise or fall depending on the movement of inflation, which is otherwise tracked by the consumer price index or the CPI.
Government bonds are very popular around the world because they are backed by the full confidence and credit of the government, which historically has always paid off its debts.
Yields and bond prices: what are they?
If you plan to hold a bond to maturity, you’ll probably want to take a look at its yield, which is simply a calculation of how much money you’ll earn on the investment.
So, for example, let’s say you have a 30-year bond of $ 10,000 (Dh36,700) with an annual interest rate of 5%. That would mean you would get $ 500 (Dh 1,835) per year. This is the annual yield on the bond. It is also called “nominal” return.
There is another factor that determines how much money you make on a bond, and that is the price.
Let’s say the owner of the above $ 10,000 (Dh36,700) bond chooses to sell the bond before it matures, for $ 9,000 (Dh3,305) – possibly because the issuing company owed it. hard to stay afloat, or because interest rates are about to drop. see a substantial increase.
The buyer of the bond will continue to earn interest based on the face value of the bond ($ 10,000 or MAD 36,700). These interest payments are fixed.
So the buyer receives the same payments, but because the buyer paid less for the bond, the yield is 5.55 percent. ($ 500 / $ 9,000 or Dh 1,835 / Dh 3,305) = 0.0555, or 5.55 percent).
When a bond sells for more than its issue value, we often hear people say that it is trading “at a premium.” If it sells for less than its issue value, it sells “at a discount.”
Generally speaking, people are looking to find bonds that sell at a discount because they offer a higher yield.
What does it mean when a bond trades at a premium or a discount?
A discount is the opposite of a premium. When a bond is sold for more than its face value, it sells at a premium. Unlike a haircut, a premium occurs when the bond has an interest rate higher than the market rate of interest (or better business history).
Why do bond prices go up and down?
The price of bonds is very strongly influenced by the interest rates of a country. The going interest rate, that is, the interest rate on bonds issued at any given time, can make any other bond more or less attractive to investors.
To illustrate this, let’s say you have a 30 year bond with an interest rate of 5%, but the rates have increased and are now averaging 6%. Because your bond now has a lower interest rate than the prevailing average, it is less attractive to investors.
So, if you want to sell the bond, you may need to lower the price to make sure investors can get the same return.
The opposite is also true. When interest rates fall, any bond with a higher interest rate becomes more attractive and may charge a higher price.
Inflation is known to have an indirect impact on bond prices because it comes with higher interest rates.
Bond prices are also indirectly affected by the performance of the stock market. When the stock market is doing well, people tend to flock to stocks and their potential for higher returns, which in turn depresses demand and prices for bonds.
But in times of economic distress, such as the pandemic-induced downturn that was recently experienced, investors will often flock to the relative safety of bonds, which can lead to higher prices.
Why Bonds Matter Now Matter Now
The bond market has become surprisingly calm in recent months, but the outlook remains good.
“As global economic growth strengthens this year, bond investors may find opportunities in high quality bonds, higher yielding debt and assets that hedge against the falling US dollar,” analysts said. of the American loan and investment firm Morgan Stanley.
Yields on government bonds edged up again in 2021. For example, the interest rate on a 30-year Treasury bond rose to around 2% at the end of August. The 10-year Treasury yield is above 1.5%.
There are many reasons why returns have increased over the years, but generally they are related to confidence in the economy and the stock market. Treasury yields rise in inverse proportion to prices. So, a high yield suggests that demand for bonds is low and prices are depressing.
The trend is only expected to strengthen. Governments around the world are expected to issue many new bonds in 2021 to cover the cost of further tax cuts. Having more bonds in the market will reduce the demand for any individual bond, so prices will fall and yields will rise.
2021: A year of recovery for bonds
âAs bond investors, we expect 2021 to be a year of recovery,â Morgan Stanley analysts predicted earlier this year.
Many economic forecasts show that GDP (gross domestic product, key indicator of economic growth) is increasing, and this begs the question: Won’t bond market yields rise in this environment? Rising yields of course mean lower bond prices, at least on paper for investors holding debt.
However, returns will rise for good reasons, based on economic growth and the return of cash flow to the markets.
âMovements in the bond market will serve as key indicators of the health of the recovery, as well as business performance and consumer confidence in 2021 and beyond,â the analysts added.
âAs economic growth strengthens (likely in inverse proportion to the severity of the pandemic this year) and the variation in the fixed income market widens, the opportunities for bond distributors will also widen. ”