Basics on Bonds

Includes: IEF, SHY, TLT
by: Mark Olivieri

Get to know Bonds

Bond prices are important because they can be used to gauge future economic conditions and future and current interest rates. Understanding the gist of Bonds is not only beneficial to a commodities or Forex trader, but also helpful for an equities trader.

The first and foremost piece of information you must know about Bonds is that its price runs inverse to its yield. Looking at Bond quotes, do not be surprised if the yield is low when the price is high. Bonds are a fall back for many investors that want to diversify their portfolio with a safe investment. When the Fed needs to cut interest rates, expect bond prices to rise. And vice versa when the Fed needs to raise interest rates. Hence, the reason for the inverse relationship between the yield and price.

Let's talk about Bond prices and quotes

Remember that a bond is a loan issued by the government and the face value is the loan amount. A bond can be purchased at either a discount or premium price. A Bond is trading at a discount when it is trading at less than its face value. If it is trading above the face value it is trading at a premium. Don't thing it is bad to purchase a bond that is trading above its price - if the coupon rate of the bond is higher than the current interest rate, this is a valuable investment. When you purchase a bond, you are also purchasing coupon payments. A coupon payment is a payment that is issued at different times throughout the course of the bond's maturity. When a Bond is traded from one owner to the next, the previous owner is entitled to a certain percentage of the couple payment until the trade is settled. Therefore, the purchase price of the bond consists of interest plus the actual price. The longer the maturity of the bond, the higher the yield. This is because within a longer period of time, there are greater risks of inflation. Therefore, the discount rate of the bond would be greater since the risk of a longer term bond is higher. The credit of the Bond's issuer is taken to affect when calculating the yield (or discount rate). In terms of riskiness, the lower the credit, the higher the discount rate.

The Yield

Since a Bond is a loan, there is a principal balance - also known as Par Value - and also known as the face value on the Bond. The yield of the bond relates this principal amount to the coupon payments, or the cash flows of the bond. The principle is usually returned at the end of a bonds maturity. A bond yield is the sum of all of its present cash flows. The cash flow is turned into a present value using the bond's yield. Therefore, it makes sense that a bond with a smaller coupon payment will have a smaller yield or present value. Calculating the bond yield is different for each bond. Some bonds have a definite maturity date, some are unknown.

Why the Yield is Inverse to Price

If inflation rates are expected to rise, interest rates will rise to cut spending. In terms of bonds, the discount rate of the bond will increase (since a bond is a measure of present interest rates) and ultimately the bond price will fall. If inflation is expected to drop, the opposite would occur.

A Final Note

When inflation is expected to rise, interest rates rise, which means the bond yield rises and the bond price falls. So, a bond can be a great measurement of future economic activity by just looking at the yield curve of bonds with different maturities. The yield is representative of interest rates. If the curve is down-trending, the economy is slowing down. If the curve is up-trending, the economy is growing. The key to this is that the yield curve is very important when deciding when to finance, take a mortgage, or select a stock.