We’ll start with a few facts about investing:
– Rising share prices and property values make for happy investors.
– An increase in interest rates results in higher term deposit rates and again, investors are pleased.
– An increase in bond yields however, does not always please investors. In fact if often leaves them confused and uncertain about the impact on their bond investments.
Read on to learn why.
The relationship between bond price and yield
There are two key components to be aware of when you buy a bond – its price and its yield.
When you buy a bond, you are effectively making a loan to that government or corporation. In return for borrowing your money, the bond is repaid in a specified time period. And, for the duration of the loan, you are rewarded with regular coupon (or interest) payments. A bond’s yield is the total value of these payments over the lifetime of the bond, incorporating the $100 face value an investor will receive at maturity. It is the total return the investor can expect to receive, subject to no default.
The coupon payment amounts are set with regard to the prevailing interest rates at the time the bond is issued. The yield is generally higher than the cash rate, to make the bond a more attractive investment than a term deposit¹.
If you buy a bond when it is issued and hold it through to maturity, the investment will not be affected by changes to interest rates. As illustrated in figure one, coupon payments remain the same for the duration of the investment, and at maturity, the principal investment is repaid.
Key point #1 – a bond bought at issue and held to maturity is not affected by changes to interest rates
Figure one: A bond bought at issue and held to maturity
Bond prices and interest rates
Key point #2 – a bond’s price moves in the opposite direction of its yield
A buy and hold strategy is straightforward. However, if you wish to buy (or sell) a bond on the secondary market (i.e. after it has been issued), the relationship between the bond’s price and its yield becomes important.
This relationship is sometimes depicted as a see-saw – as one rises, the other falls. As illustrated in figure two, the two factors have an inverse relationship; in other words, a bond’s price moves in the opposite direction of its yield.
Figure two: the effect of interest rates on bond yields and bond prices
Why bond prices and yield are inversely related
The price of a bond reflects the value of the income it provides via regular coupon or interest payments.
If interest rates fall, the value of investments related to interest rates fall. But bonds that have already been issued will continue to pay the same coupon amount as they did previously – a rate which was based on a higher interest rate at the time they were issued. These older bonds then become a more attractive proposition and will generally sell at a premium.
When interest rates rise, term deposits and newly issued bonds will pay investors higher rates than existing bonds. Therefore, the price of older bonds will generally fall to compensate and sell at a discount.
Key point #3 – when a bond sells at a discount, its price is lower than its issue price. When it sells at a premium, its price is above its issue price.
How the bond price and yield relationship affects XTBs
As well as an original face value and coupon rate, each XTB has a current price, a current yield determined by its coupon rate and price, and a yield to maturity.
We provide a table of available XTBs, which is updated daily using the previous market close data. This interactive table provides details of the available XTBs, and includes fixed and floating rate bonds across a range of sectors.
Figure three: Key measures of a corporate bond
|COUPON RATE||FACE VALUE||CURRENT PRICE||CURRENT YIELD||YIELD TO MATURITY|
The amount returned to investors at maturity
The amount investors pay for this XTB on ASX
(coupon/price) x 100
The total return you should receive if you hold to maturity. It is the best measure for investors.
Source: AGL XTB – YTMAGL 05 AUG 2020
Figure three details the data you should review when considering an investment in an XTB. This example shows an XTB where interest rates have decreased (the current yield is lower than the coupon rate). Therefore, this XTB’s current price is higher than its face value:
- The coupon rate of 5.00% would be paid to those investors who bought at issue (at $100) and held to maturity
- An investor who bought at issue and sold this XTB today would profit from the price appreciation
- An investor buying the XTB today would pay a higher price than its face value.
Key point #4 – the Yield to Maturity is the ‘total return’ you should receive if you buy the bond today and hold it to maturity
If you are considering XTBs for your portfolio, use the tools available to help you determine the most appropriate investment(s), given your income needs and likely investment time frame.
¹Term Deposits may enjoy the benefit of protection under the Financial Claims Scheme.
This article was first published in August 2017 and updated in August 2020