Expert: Doug Ingram - 3/3/2008

Question
Hi Doug,

If you would be able to enlighten me as to whether when bond prices fall this leads to yields rising and vice versa and discuss around this point, it would be much appreciated.

Many thanks,

Tobias

Answer
The bonds you are referring to have a fixed coupon so they are worth more if yields fall.

If a bond has a 5% coupon and the prevailing rates fall to 4%, the bond is worth roughly 1% more per year.

If yields rise to 6%, the 5% bond would see its price fall to reflect that that bond only earns 5% per year.

For instance: A one year bond earning 5% when yields fall to 4% is going to be worth 101 instead of 100.  The 101 + 5% would be worth only $105 less 1$ or $104 since we paid a 1% premium.  The 4% bond at par ($100) would be worth the same $104 at year end.  Generally speaking, bonds of similar type, quality, and maturity trade near the same yields.

If rates rise to 6%, the 5% bond would have to be offered near $99 to earn the same as a 6% par bond.  The price fell because we could have bought a 6% bond at $100, so we would expect to get a 1% discount for things to "match up".

You can view the past answers where I covered this in detail.