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Understanding Yield and the Effects of Rising Interest Rates

Think of yield as the return provided by a fixed income investment. The yield of a bond is based on both the purchase price of the bond and the interest (or coupon) payments received each year. Yield is often the term used to describe long-term interest rates.

     Yield = Coupon
Bond Purchase Price

Why Rising Interest Rates (and Yields) Push Down Bond Prices

Interest rates and bond prices have an inverse relationship. When interest rates fall, bond prices usually rise and when interest rates rise, bond prices usually fall.

Example
An investor buys a new bond for $1,000 that has a 6% interest payment (yield) earning $60 in interest each year. (This interest payment is generally referred to as a coupon.) If interest rates increase by 1%, new bonds will provide a 7% interest payment, paying investors $70 annually. Because investors will now be able to buy a bond with a higher interest payment (higher yield), not as many people will want to buy the 6% bonds. This decline in demand will cause the value of the 6% bond to fall.

The key point is that a bond’s yield will rise when the value of the bond declines. So when bond yields (or interest rates) rise, it actually means that the value of bonds in general is declining. This is why rising bond yields are generally considered to be undesirable for existing bond investor.

 

Courtesy Trilogy Mtg.

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