Back to basics: Understanding yield and the effects of rising rates

Summary

This video explains the concept of bond yields, detailing how the yield represents the total earnings from a bond over a set period. It covers factors influencing bond yields, such as market conditions, creditworthiness, inflation, and interest rates. The video also explores the inverse relationship between bond yields and prices, and introduces the concept of bond duration, which measures a bond's sensitivity to interest rate changes. Investors are encouraged to match bond duration with their investment horizon and understand the potential benefits of reinvesting coupon payments at higher yields.

Takeaways

• 📈 Yield refers to the total return earned from a bond over a specific period.
• 🌐 The yield is influenced by the current market conditions, reflecting how much investors demand for lending money to an issuer.
• 💵 The yield of a bond depends on its price, coupon rate, and term to maturity.
• 📉 Bond prices and yields have an inverse relationship: when yields rise, bond prices fall, and vice versa.
• 🔍 An example: if you buy a bond at $1,000 with a 6% coupon, your yield matches the coupon rate if purchased at par.
• 📊 If market yields increase, new bonds offer higher interest, reducing demand for lower-yield bonds, causing their prices to drop and yields to rise.
• ⏳ Duration measures a bond’s sensitivity to interest rate changes and is expressed in years.
• 🕰️ Generally, the longer the bond’s maturity, the higher its duration, meaning its price is more sensitive to yield changes.
• 📅 For bond funds, a recommended strategy is matching the duration with your investment time horizon.
• 💡 Even if bond prices fall, reinvesting coupon payments at higher yields over time can offset price declines.

Q & A

What is the definition of 'yield' in the context of bonds?

Yield is the total amount earned from a bond over a set period of time, influenced by factors like the current market climate, bond price, coupon rate, and the bond's term to maturity.

How does the market climate influence bond yields?

The market climate, which reflects how much investors can demand for lending money, influences bond yields. When the market climate changes, so does the amount investors expect in return for lending.

What is the relationship between bond price and bond yield?

Bond price and bond yield have an inverse relationship. When bond yields rise, bond prices fall, and when bond yields fall, bond prices rise.

How does a change in interest rates impact the price of a bond?

Changes in interest rates set by central banks can influence bond prices. For example, when interest rates rise, bond prices typically fall, and vice versa.

What factors can affect the price of a bond?

Factors that affect the price of a bond include the creditworthiness of the issuer, the overall economic outlook, inflation rates, and interest rate changes set by central banks.

How does an increase in market yields affect existing bonds?

When market yields increase, new bonds offer higher interest payments, which makes existing bonds with lower interest rates less attractive, causing their prices to fall and their yields to rise to match the market.

What is 'duration' in bond investing?

Duration is a measure of a bond's sensitivity to changes in interest rates. It is expressed as the number of years, with longer durations indicating higher sensitivity to rate changes.

How does a bond's duration impact its price when yields change?

A bond’s price will either rise or fall by a percentage roughly equal to its duration for every 1% change in yield. For example, a bond with a four-year duration will see its price change by 4% for every 1% change in yield.

Why is it important to consider duration when investing in bond funds?

It is important to match the bond fund's duration to your investment time horizon. This helps manage the risks associated with interest rate changes and the sensitivity of the bond prices.

What can investors do if bond prices fall due to rising yields?

Even if bond prices fall, investors can reinvest their coupon or interest payments at the new higher yields. Over time, this higher reinvestment rate can help offset the decrease in bond prices.