Bond Price Vs Yield

The common terms that investors come across while investing in bonds are bond price, coupon rate, face value, bond yield and yield to maturity. While the coupon rate is the interest rate, face value is what the issuer pays to investors on maturity. Yield to maturity is the total return that an investor is estimated to receive if the bond is held till maturity. However, bond price vs yield are interrelated and explain how bonds work. 

What Is Bond Price Vs Yield?

Bond price is the present value of a specific bond’s future cash flows. Based on the supply and demand for bonds, the bond price fluctuates. In other words, it is the price that you need to pay to purchase the bond. It can be higher, lower or equal to the face value of the bond.

On the flip side, bond yield is the percentage of earnings that investors realise after a certain duration. In other words, bond yield is the return that you earn on the bond price. The yield of a bond varies based on the price of the bond. 

However, the coupon rate or interest rate remains fixed during the entire tenure. Investors earn annual or semi-annual interest income based on the coupon rate. 

Relationship Between Bond Price Vs Yield

Bond price and yield have an inverse relationship. Consider the following instances to understand the relationship between bond price vs yield:

• If the bond price is lower than the face value of the bond, the yield will be higher than the coupon rate.
• In case the bond price is higher than the face value of a bond, the yield will be lower than the coupon rate.
• If the bond price decreases, the bond yield increases.
• When the bond price increases, the bond yield decreases.

Here are the reasons why the relationship between bond price vs yield is inverse:

1. When there is a decrease in the interest rate, the value of the associated investments will fall. However, the bonds previously issued will continue to pay higher interest rates to the existing investors. The high coupon rate or interest rate makes these bonds attractive among investors who want to buy them.
2. If the interest rate of bonds increases, investors can earn higher interest income compared to their existing bonds. As a result, investors will prefer to invest in new bonds and sell their old ones. This results in a decrease in bond prices wherein investors want to sell old bonds at a discounted price. 

Consider the examples below to understand the inverse relationship between bond price vs yield:

Scenario 1:

Bond Tenure: 10 years

Bond Price: ₹5,000

Coupon Amount: ₹200

Yield = Interest on Bond/ Market Price of the Bond * 100 = (₹200/₹5000) * 100% = 4%

If the bond price now increases to ₹5,500 due to high demand among investors, the bond will be traded at a 10% higher price than the issue price. The coupon rate remaining unchanged at ₹200, the yield will be as follows:

Yield = (₹200/₹5500) * 100% = 3.64%

Thus, when the bond price increases, the bond yield decreases. 

Scenario 2:

Bond Tenure: 10 years

Bond Price: ₹5,000

Coupon Amount: ₹200

Yield = 4%

If the bond price falls to ₹4,300, the yield will be as follows:

Yield = (interest on bond/ market price of bond) * 100% = (200/4300) * 100% = 4.65%

Thus, when the bond price falls, the bond yield increases. 

Difference Between Bond Price and Yield

Here are the key differences between bond price vs yield:

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Formula and Calculation of Bond Yield

Here is the formula to calculate bond yield:

Bond Yield = (Coupon Amount/ Market Price (Face Value) of the Bond) * 100

For instance, if the coupon amount of a bond is ₹400 and the market price of the bond is ₹10,000, the bond yield will be as follows:

Bond Yield = ₹400/ ₹10,000) * 100 = 4%

Factors Affecting Bond Price

Interest rate is the key factor that affects the bond price. However, here are the factors that affect the interest rate and in turn the bond price:

1. Duration

Based on the duration of a bond, the bond is sensitive to interest rate fluctuations. A bond with a longer maturity tenure is more vulnerable to changes in interest rates. As a result, it is more susceptible to risks compared to a bond with a shorter maturity tenure. 

1. Issuer’s Financial Health

The interest rate offered by the issuer significantly affects bond prices. An issuer with a lower credit rating will likely offer a higher interest rate to investors to boost bond purchases. However, an issuer with a high credit rating will likely offer a lower interest rate. Ensure you check the credit rating of the issuer before purchasing a bond. 

1. Inflation

Inflation in the economy results in a higher interest rate on bonds. This leads to a decrease in the bond price. As a bond faces challenges in keeping up with the inflation rate, it reduces the price to pay less than the required amount. 

Thus, with changes in bond price due to fluctuations in the interest rates based on the bond duration, issuer’s financial health and inflation, the bond yield will increase or decrease. 

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