Bonds are an important part of the financial market and act as a crucial source of capital for corporates and the government. When it comes to trading in fixed-income securities, it is important to understand the concept of bond yield. In the mutual fund sphere, debt-oriented funds such as short-term mutual funds, invest in bonds to provide investors with short to medium term investment horizons and an opportunity to earn good returns.
Let us understand more about bonds and the factors that affect them.
What is a bond?
It is a debt instrument that provides investors with a steady income stream via interest payments and repays the principal amount on a pre-defined maturity date.
Terms you should know
1. Bond price:
Simply put, it is the present value of the bond’s future cash flows. Bond prices rise or fall according to the supply and demand of the bonds.
2.Coupon rate:
This is the periodic interest rate paid to the purchasers by the issuers on the bond's face value.
3.Face value:
Also called par value, it is the price that the bond issuer pays at the time of the bond’s maturity
4.Bond yield:
This is the expected earnings realised over some time, represented by a percentage.
5.Yield to maturity:
This is the total return anticipated on a bond if it is held until its maturity.
Relationship of the bond price and yield
The yield and bond price have an important but inverse relationship. When the bond price is lower than the face value, the bond yield is higher than the coupon rate. When the bond price is higher than the face value, the bond yield is lower than the coupon rate. So, the bond yield calculation depends on the price of the bond and the coupon rate of the bond. If the bond price falls, the yield rises, and if the bond price rises, the yield falls. Let us understand why this is the case:
1. When interest rates fall, it causes a fall in the value of the related investments. However, bonds that have been issued will not be affected in such a way. They will keep paying the same coupon rate as issued from the beginning, which will now be at a higher rate than the prevailing interest rate. This higher coupon rate makes these bonds attractive to investors willing to buy these bonds at a premium.
2. Conversely, when interest rates rise, newer bonds will pay investors better interest rates than existing bonds. Here, the older bonds are less attractive and will drop their prices as compensation and sell at a discounted price
Examples of the inverse relationship between bond price and yield
Example 1
There is a 10-year bond with a price of Rs 5000 and a coupon amount of Rs 200. The yield on this bond is calculated as per the formula below
● Yield = interest on bond / market price of the bond x 100
● So, yield = (200/5000) x 100% = 4%
Suppose the price of the bond increases from Rs 5000 to Rs 5500 due to strong investor demand. So, the bond now trades at a price of 10% above the issue price. However, the coupon amount remains the same at Rs 200.
● Now the yield changes to (200/5500) x 100% = 3.64%
So, the bond price has gone up, which causes the yield on the bond to decrease.
Example 2
Now suppose the price on the same bond considered above decreases.
● Initial bond price = Rs 5000
● Coupon = Rs 200
● Bond price falls to Rs 4300
● Coupon remains Rs 200
● Now yield is (200/4300) x 100% = 4.65%
Due to the inverse relationship between bond price and bond yield, the yield has now gone up. You can also invest in short-term mutual funds for similar benefits.
Mutual Fund Investments are subject to market risks, read all the scheme related documents carefully
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