(PUB) Investing 2015

The Independent Adviser for Vanguard Investors

•

July 2015

•

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800-211-7641

and measures of maturity versus dura-

tion that the confusion often begins to

set in and eyes glaze over, so take this

in manageable bites and it will all begin

to make sense.

The Price-Yield See-Saw

Probably the most important thing

to understand about bonds is the rela-

tionship between prices and yields.

If you can remember that these two

important components move in dia-

metrically opposite directions, you’ll be

a long way to understanding much of

what you need to know about the bond

market. To many, this inverse relation-

ship describes

interest rate risk

, or

the risk that a bond’s price will fall if

interest rates rise. Most journalists and

pundits assume (wrongly, I believe)

that everyone understands why that

happens. It’s not intuitive, however, so

let’s use a simplified example to take a

closer look.

Let’s say the U.S. government wants

to borrow some money. They issue

a Treasury bond (or, technically, a

Treasury “note” if it will be repaid in

less than 10 years, or a “bill” if it’s going

to be repaid in as little as three months).

On the day of issuance, they agree to

pay you 2% a year (the coupon rate)

until June 30, 2025 (the maturity date).

You buy the bond for $100. At 2%, you

will receive $2 a year in interest ($1

every six months, since Treasurys pay

semianually) until the maturity date,

when you get your last coupon payment

and the full $100 face value of the bond

back. Your return over the course of the

loan will have been 2% a year, the same

as the coupon.

A quick aside on bond parlance:

When a bond is trading at its face value,

that’s called

par

, and it’s expressed

in bond price quotes as $100. In our

Treasury bond example, the new bond

you bought at $100 trades at par, as

most newly issued bonds do. At times,

new bonds are priced at a premium

(above par), and sometimes at a discount

(below par), but typically you see bonds

trading at premiums and discounts after

they have been issued.You’ll see why as

I get back to the example, sticking with

$100, par-issued bonds.

Now let’s pretend that the day after

you bought the bond, the U.S. govern-

ment realizes it didn’t borrow enough

money (imagine that!), so it decides to

issue another 10-year bond. However,

overnight a report came out indicating

that inflation is rising rapidly and prices

are going up, up, up. As a consequence,

investors immediately begin demand-

ing a greater rate of return when lend-

ing money. Interest rates rise 1% as

soon as the bond markets open, and

when the U.S. Treasury offers its new

bonds, they have to offer a coupon of

3% rather than the 2% they offered just

one day earlier.

So ask yourself this question: Which

bond would you rather own—the bond

paying 3% interest or the one paying

2%? Which bond should have more

value to investors?

If you could sell your day-old 2%

bond for the $100 you paid for it and

buy the new 3% bond for $100, you

would—it’s the same issuer and has

the same maturity (less a day), so

there’s basically no difference other

than the coupon. But that’s not going

to happen. No one will give you $100

for your 2% coupon bond when the

same $100 will buy them a bond with

a 3% coupon. However, they might be

willing to pay less than $100 for the

day-old bond.

And that’s just what happens. Prices

in the bond market adjust (in this case,

downward) so that the yield on your

day-old 2% bond matches the yield on

the brand new 3% bond. In a nutshell,

this is why bond prices fall when inter-

est rates rise. (The corollary, of course,

is that bond prices rise when interest

rates fall.)

The investor who purchases a 2%

bond at a discount to face value and

holds it to maturity will earn the same

3% as the buyer of the new 3% bond.

But the original buyer of the 2% bond

loses money on the sale. If the buyer

of the 2% bond holds it to maturity, he

gets his 2% per year, plus his money

back at maturity, but he’s locked his

money in at 2%, when he could have

gotten 3% a day later.

Yields vs. Interest Rates

You’ll notice that I slipped the word

“yield” into that last explanation. This

difference between interest rates and

yields is a key characteristic of bonds

that often trips people up.

As I explained, a bond’s interest rate

or coupon rate is a fixed percentage

that describes how much the borrower

is paying for lending them money. It’s

the rate that is fixed to that particular

bond. It never changes. (There are

some bonds where the interest rate does

change based on other variables, but

let’s try to keep this as simple as pos-

sible here.)

The

yield

, on the other hand,

describes your expected annual total

return based on the coupon rate as

well as the price you pay for that bond

assuming you hold it to maturity. When

you buy a bond at par, your yield will

be the same as the coupon.

To illustrate, let’s go back to my

example of the U.S. Treasury issuing

identical bonds one day apart with two

different coupons, 2% and 3%. When

you buy the 3% Treasury at par, you

are paying $100 for $100 worth of

bonds and can expect to receive $100

at the maturity date. Meanwhile, you

will receive $3 in interest each year.

So your yield is 3%, the same as the

coupon.

But what about the day-old bond

with the 2% coupon? No matter wheth-

er you buy it on the day it’s offered or

one day or one year later, you’ll still

get $2 per year from the U.S. Treasury,

because that is the contracted (fixed)

coupon on that bond. And at the matu-

rity date, the U.S. government is still

going to pay back the $100 face

Bond pricing, yields, maturity and duration can

cause confusion to set in and eyes to glaze over,

so take it in manageable bites.