- Bond Yield: Bond yield refers to the return an investor receives on a bond investment, usually expressed as an annual percentage. It represents the bond’s interest income relative to its current market price or face value.
- Bond Price: Bond price is the market value of a bond, indicating how much investors are willing to pay for it in the secondary market. It’s influenced by factors such as prevailing interest rates, credit quality, and maturity date.
Illustration:
- Rising Yields, Falling Prices: When market interest rates rise above a bond’s coupon rate, newly issued bonds offer higher yields. As a result, existing bonds with lower yields become less attractive to investors, causing their prices to decrease to align with the new higher yields.
- Falling Yields, Rising Prices: When market interest rates decline, newly issued bonds offer lower yields. Existing bonds with higher yields become more attractive, leading investors to bid up their prices to obtain these higher yields.
- Example: Suppose you hold a bond with a fixed coupon rate of 5%, and prevailing market interest rates rise to 6%. In this scenario, investors demand a higher yield to compensate for the lower coupon payment relative to new bonds. As a result, the price of your bond decreases to increase its effective yield to 6%.
Inverted Yield Curve:
- An inverted yield curve occurs when short-term yields surpass long-term yields, resulting in a downward yield curve slope
- This phenomenon often indicates a belief among investors that future policy interest rates will be lower than the current rates.
- In certain countries like the United States, an inverted yield curve has historically foreshadowed an economic downturn. This is because central banks typically lower policy rates in response to sluggish economic growth and inflation, which investors may accurately predict.
Why is the Yield Curve Important?
- Central to the transmission of monetary policy
- A source of information about investors’ expectations for future interest rates, economic growth and inflation
- A determinant of the profitability of banks.
