How Does the Bond Market Work?

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Attempting to understand how the bond market works can be confusing at first. Many people are confused by the various terms associated with bonds, such as “yield” and “price”. Most do not understand the differences between the two. However, understanding this difference is key in comprehending how the bond market works.

Bond Market Fluctuations

Although many think of bonds as a long-term investment vehicle in which investors hold the bond until maturity, this is not always the case. The price of a bond can fluctuate significantly which can prompt investors and traders to buy and sell bonds. Essentially, bonds can be free traded on the market just like any other type of financial security.

Yield

The yield of a bond is a figure expressing the return a person receives on a bond. Yield can be calculated by dividing the coupon amount by the price. When an investor purchases a bond at par, the yield is equal to the interest rate. Therefore, when price fluctuates, yield also changes.

For example, when one purchases a bond with a coupon of 10% at $1,000 par value, the yield is equal to 10% ($100/$1,000). However, if the price of the bond depreciates to $800, then the yield increases to 12.5%. This is calculated by the following by dividing $100 by $800. On the other hand, if the price increases to $1,200, the yield will decrease to 8.33% ($100/$1,200).

Factors Affecting Bond Markets

Essentially, when the price of bonds increase yield moves downward, while the opposite is true when bond prices decrease. Therefore, a bond’s price is inversely related to its yield. There are various factors which can influence fluctuations in bond prices. However, the most relevant factor is prevailing interest rates of an economy.

How Interest Rate Fluctuations Affect Bonds

Rising interest rates cause falling bond prices which results in higher yield of older bonds. This aligns the older bonds with new bonds being issued at higher coupons. When interest rates decrease, bond market prices rise, causing lower yields of older bonds. This aligns older bonds with new bonds issued at lower coupons.

This information is important to comprehend when looking to make decisions on utilizing bonds in one’s investment portfolio. On the other hand, each individual’s investment goals can vary widely which means that the proportion of the portfolio that consists of bonds will be different with each person. Therefore, a person should decide upon how much risk he or she is willing to take and invest accordingly.

 

Writer Bio

LeBach PhamLe Bach Pham has been writing professionally after receiving his Bachelor’s of Art in English Literature from the University of California, San Diego in 2002. He now specializes in writing about legal, business and financial topics. Pham also earned a Paralegal Certificate from the University of San Diego and has experience working in the legal field. He also has experience in writing business plans for clients from various fields, including banking, finance, retail, education, beauty and various other sectors.

Sources:

http://www.investopedia.com/university/bonds/bonds3.asp

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