Bond Trading Question
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I'm in uni doing an arts degree moving into finance. I'm learning about bond pricing/yield relations, but the rationale from an investor's perspective isn't clicking. I get why bond price/yields are inversely related. As interest rates go up, new bonds are issued at a higher rate so "old" bond's price drops thereby sending yield up. Opposite happens in a decline rate environment.
Question: Say I bought a 5 year bond 2 years ago at 5% (fake numbers here). Interest rates increase to 7% (fake number) so my bond is now trading at a discount to match. I am still getting 5% (even though the price has dropped), correct? The price drop would only be relevant to new prospective buyers of the "old" bond because it would now return 7% to match market conditions?
Effectively, I'm confused on how the yield changes (if it does at all) to investors who have owned a bond and then for prospective buyers of said bond given a change in interest rates.
Further, if anyone could explain why this means the bond bond market got decimated this year I would greatly appreciate it as I don't see why (if you had bonds at x% and rates rose, would you still not be getting the % you signed up for)?
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Yield is more of an at purchase metric I believe. If you buy a bond yielding 10%, and then the price drops so it’s yielding 15%, you still are going to realize a yield of 10%. Key is “fixed” income. Think of yield as being “fixed” when you buy into it (assuming you hold until maturity).
1. the price drop would also be relevant to you if suddenly needed to sell your bonds, and also for daily MTM/pnl calculations.
2. if you already own a 5% bond, assuming you bought it at part and will hold until maturity, your YTM will remain 5% regardless of how market interest rates move. however, if rates increase to 7%, then yes the YTM for a prospective buyer will increase to 7% since the price at which they pay for this bond will drop below par.
3. If you already own bonds with 5% YTM, assuming you hold to maturity, yes you will still be yielding 5% regardless of how the bond market moves, the "bond market getting decimated this year" impacts you through MTM - the valuation of your bond would have fallen, which would be reflected in your PNL calculations (see #1). If you suddenly had to sell your bond for whatever reason, you'd have to sell it for lower than that you bought it at.
Very helpful. Thank you!
The difference is about holding to maturity vs. trading for total return. Individual bond holders do a lot of holding to maturity. They don't care about current yield at all as that's a percentage of pricing. They care about the actual distribution which will be unchanged until maturity unless the bond issuer defaults or calls the bond (it it was a callable bond). As an example, a retired person might have $1mil in bonds. Let's say the bonds pay a coupon of 5% and they take that dividend in cash. If they plan on holding to maturity, they will get 50k per yr until the bonds mature and then they will get back their principal. Rinse and repeat. FI. Nominal Risk is simply default. Real risk is inflation. But they may not care, from a total return standpoint, if their bond portfolio is worth 900k or 1.1M. They care about getting their 50k income AND their 1M at maturity.
A bond fund, however, is constantly buying and selling to increase yield and total return. Bond fund managers got crushed in 2022 because their bonds lost value due to a rising rate environment. If they were holding to maturity, who cares? But they don't. They're managing to be competitive against indexes and other funds.
Big difference between a retail investor who buys a bond fund vs. a bond ladder. The former is subject to current market risk / pricing. The latter (no pun intended) is all about guaranteed return, set and forget. Many corporate bond funds (IG and HY) fell more that the S&P in 2022. Not always a safe haven when bond pricing shifts dramatically.
This is great. Thank you!
There is also different ways companies can account for their bonds. If the company intends to hold the bond until maturity like the retiree in the above example, they can classify the bond on their financial statements as “held till maturity” and not mark the capital gains or losses from the bond on their financial statements.
On the other hand, if they are like a bond fund or they do intend to actively trade their bond portfolio, they have to classify it as “available for sale” and mark their holdings to the market price.
That way companies that just want the dividends and don’t intend to sell the bond don’t have their income statements not match the reality of them never selling the bond.
not sure how much each classification is used in the real world- I imagine most bond owners will mark-to-market but that’s how the accounting behind it works.
All the confusion comes from thinking about the coupon in % terms, which then leads to confusing it with yield. Think about the coupon in dollars, not %, and the rest will make sense.
The 5% coupon means you're making $5 a year (you didn't specify bond was purchased at par, but let's assume par to illustrate). The coupon won't change, so think of it as $5 and never again think of it as 5%.
Your yield will change all the time. Bond falls to $70, your yield is now 7.1%.
I understand what you mean by "that only matters to new buyers" but think of it the following way instead. $70 is what you can get today for your bond. By choosing to hold it (instead of sell), you're foregoing $70 cash and choosing to earn a $5 coupon. Financially, that's identical to buying the bond . . a buyer is foregoing $70 cash to earn a $5 coupon. It's the same yield decision whether you're a current holder or a new buyer.
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