How The Bond Market Works
Bonds are loans that investors make to governments, corporations, and other entities. The borrower agrees to pay the lender periodic interest payments (coupons) and to repay the loan principal (face value) when the bond matures. In return, the lender receives a stream of income and a measure of safety.
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Most bonds have a term of 10 years or longer. When a bond matures, the issuer repays the face value of the loan to the bondholder.
Bonds are issued in a primary market, where the issuer sells the bonds to investors, and a secondary market, where investors trade bonds among themselves. The prices of bonds traded in the secondary market are determined by the forces of supply and demand. The prices of bonds traded in the primary market are set by the issuer.
The market for U.S. Treasury bonds is the largest and most active bond market in the world. Treasury bonds are issued by the federal government to finance the national debt. These bonds are considered to be the safest investments because they are backed by the full faith and credit of the U.S. government.
The yield on a bond is the return that an investor receives from holding the bond. The yield is the interest rate that the issuer pays, plus or minus any changes in the price of the bond. The yield is usually expressed as a percentage of the bond’s face value.
The yield on a bond can be measured in different ways. The most common measure is the yield to maturity, which is the yield that an investor would receive if he held the bond to maturity and reinvested all the interest payments at the same interest rate.
The yield to maturity is the best measure of a bond’s yield because it takes into account all the interest payments that will be made over the life of the bond, as well as the bond’s price at maturity.
Bond prices and interest rates move in opposite directions. When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise. This relationship is known as the “inverse relationship” between bond prices and interest rates.
The reason for this relationship is that when interest rates rise, the value of a bond’s future interest payments falls. For example, if a bond has a face value of $1,000 and a coupon rate of 5%, the bond will pay $50 in interest each year. If interest rates rise to 6%, the bond’s interest payments will be worth less because investors can get a higher return by investing in a new bond with a 6% coupon rate. As a result, the price of the 5% bond will fall to offset the lower value of its interest payments.
The inverse relationship between bond prices and interest rates also works in the reverse direction. When interest rates fall, the value of a bond’s future interest payments rises. As a result, the price of the bond will rise to offset the higher value of its interest payments.
The relationship between bond prices and interest rates is known as the “price/yield relationship.”
The price/yield relationship is an important concept for bond investors to understand because it affects the price of bonds that they buy in the secondary market.
When interest rates rise, the prices of bonds fall, and when interest rates fall, the prices of bonds rise. This relationship is known as the “inverse relationship” between bond prices and interest rates.
The reason for this relationship is that when interest rates rise, the value of a bond’s future interest payments falls. For example, if a bond has a face value of $1,000 and a coupon rate of 5%, the bond will pay $50 in interest each year. If interest rates rise to 6%, the bond’s interest payments will be worth less because investors can get a higher return by investing in a new bond with a 6% coupon rate. As a result, the price of the 5% bond will fall to offset the lower value of its interest payments.
The inverse relationship between bond prices and interest rates also works in the reverse direction. When interest rates fall, the value of a bond’s future interest payments rises. As a result, the price of the bond will rise to offset the higher value of its interest payments.
The relationship between bond prices and interest rates is known as the “price/yield relationship.”
The price/yield relationship is an important concept for bond investors to understand because it affects the price of bonds that they buy in the secondary market.