Bond Yields ReCap Notes

Note: Mortgages are generally packaged and sold as bonds, called mortgage backed securities.  So watching bond yields gives a good indication of the direction of mortgage rates.

ALL RIGHT, we might as well dive right into the yield and price mess. Since the first bond hit Wall Street, it's the thing that has most confused beginning investors. You've probably heard the mantra at least once before: When yield goes up, price goes down, and vice versa. But if you're like most people, you haven't the faintest clue why.

Well, here goes...

So far, we've discussed bonds as if investors always buy and hold them until they mature. A lot of people do just that, but many others -- including the pros -- buy and sell them on the open market before they reach maturity. Consequently, the price of a given bond can fluctuate -- sometimes wildly. That means it's unlikely you'll ever be able to sell a bond for "par," or 100% of its face value.

We'll explore what drives price changes in the next section, but for now, consider what happens when the price goes up or down. As you already know, a bond's periodic coupon and its ultimate payout never change once the bond is issued. Consider a 30-year bond with a face value of $1,000 and a 6% ($60) coupon. If the price falls to $800, you'll still get $60 each year in interest and $1,000 when the bond matures. The same holds true if the bond's market price jumps to $1,200. Obviously, then, the $800 bond is a much better deal -- you're getting the same payout for $400 less.

OK, So What Does 'Yield' Mean?

Yield -- a bond-speak standard -- is a figure that captures this change in value. It's the percentage return your bond investment promises at any given price.

In its most simple incarnation -- known as "current yield" -- it can be expressed with this formula: Yield = Coupon/Price. When you buy a bond for face value, the yield is simply the coupon, or interest rate. But when the price fluctuates, the yield grows or shrinks to compensate in either direction.

Let's look at that 6% bond again. If you were to buy it for $1,000, the current yield would simply be 6% ($60/$1,000). But if the price drops to $800, the yield rises to 7.5%. Why? Because the guaranteed coupon -- $60 -- is now 7.5% of the $800 you paid for the bond ($60/$800). If the price rises to $1,200, the percentage shifts down to 5%.

Yield to Maturity

Unfortunately, it gets even more complicated. In the real world, when people talk about yield, they're really talking about another figure, called "yield to maturity." This represents the total return you can expect if you buy a bond at a given price and hold it until it matures.

Yield to maturity includes the fact that the bond you bought for $800 will pay you $1,000 when it's due. It also assumes you reinvest the coupons at the same rate and figures in the compounding effect. If, in the above example, you add that $200 difference and the effects of reinvested coupons, the yield to maturity calculates out to 7.73% -- a significantly better deal than the original coupon of 6%.

Once you've grasped the inverse relationship between price and yield, you're ready to take on the bond market's next puzzler: If yields and prices move in opposite directions, how come both high yields and high prices are considered good things?

The answer depends on your perspective. If you're a bond buyer, high yields are what you're after, because you want to pay $800 for that $1,000 bond. Once you own the bond, however, you're rooting for price. You've already locked in your yield, and if the price rises, it can only be a good thing -- especially if you need cash someday and want to sell the bond to get at it.

Risk vs Reward - what changes the price?

JUST BECAUSE BONDS have a reputation as conservative investments doesn't mean they're always safe. Any time you lend money, after all, you run the risk it won't be paid back. Companies, cities and counties occasionally do go bankrupt or default on their debts for extended periods. U.S. Treasury bonds alone are considered rock-solid. In fact, economists label the yield of the shortest-term U.S. bonds "the risk-free rate of return."

Paradoxically, another source of risk for certain bonds is that your loan may be paid back early, or "called." This is known as prepayment risk. While it's certainly better than not being paid back at all, it forces you to find another, possibly less lucrative, place to put your money. When you buy a bond, the prospectus will indicate whether a bond is callable and give you a "yield-to-call" figure. If you have a choice, buy a bond without the call option.

All bonds are sold at a discount. When, for example,  the Federal National Mortgage Association (FNMA) issues a $100,000 bond, they sell the bond for a discount, say $97,000. In 30 years, when the purchaser presents this bond for payment, FNMA gives the purchaser $100,000, and the purchaser has earned $3,000 in interest over a thirty-year period.

So a bond investor’s worst nightmare is inflation. When inflation begins, the price of bonds move down, causing a higher interest rate. Why? Because a bond investor is investing today’s dollars for a pay out thirty years in the future. In an inflationary period, these investors would only be willing to pay, say $94,000 for that $100,000 bond, since the money will be worth less in thirty years.

Inflation
By far, the greatest danger for a buy-and-hold bond investor is a rising inflation rate. Nothing spooks bond traders more than cheerful headlines about full employment or strong economic growth. When the economic news is good, the bond markets often take it as a bad sign -- a harbinger of an impending period of slowly rising consumer prices. The hotter the economy, the worse the threat. And the more downward pressure on bond prices.

Why is inflation such a problem for bondholders? Think about it this way: Rising prices make today's dollars worth less in the future than they're worth today. Since a bond can lock up your money for as long as 30 years, a rising rate of inflation can have a particularly corrosive effect.

All this explains why bond traders live in a hall of mirrors. What you or I might consider good news, they often consider bad. The bond market itself is a minute-by-minute referendum on the threat of inflation. If the threat is high, prices fall and yields -- or interest rates -- rise. This is often an excellent time to buy bonds. But if you own them already, you're stuck.

Yield vs. Risk
Inflation risk, credit risk and prepayment risk are all figured into the pricing of bonds. The more risk, the higher the yield. It's also true that investors demand higher yields for longer maturities. The reason for that is obvious -- given enough time, a once-healthy corporation can go bankrupt and suddenly lose the ability to pay its obligations. Inflation could run rampant, seriously eroding the purchasing power of that $1,000 you're supposed to get back in 30 years. These things are unlikely or you'd never invest in the first place. But the longer you tie your money up in a bond, the more at-risk it is statistically.

The credit quality of companies and governments is closely monitored by the two major debt-rating agencies; Standard & Poor's and Moody's. They assign credit ratings based on the entity's perceived ability to pay its debts over time. Those ratings -- expressed as letters (Aaa, Aa, A, etc.) -- help determine the interest rate that a company or government has to pay when it issues bonds. The market determines the price -- and thus the yield -- after that