Money Market

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Understanding the Inverse Relationship between
Bond Prices Yields By Prof. Simply Simple TM
Why do bond yields go up when bond prices go
down?
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You might have come across a set rule which
states, When bond prices goes down, bond yield
goes up vice versa. This rule is then simply
memorized and never questioned. Memorizing
without questioning makes concepts dull and
boring but understanding, on the other hand,
makes concepts come alive.
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I am sure you will agree that when the seller of
a good sells at a lower cost, he makes a lower
profit. However, in the same deal the purchaser
of the good makes a gain due to the attractive
price of purchase.
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Hence when a seller of a bond sells it at a
reduced price, while he loses, the buyer of the
bond gains from the transaction.
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Thus the loss for the seller is the fall in price
while the gain for the buyer is the benefit of
higher yields.
6
Now lets understand with a simple
example. Lets assume that Ravi has a corporate
bond of Rs 100 which is to give him 10 returns
per annum. In other words, the company would
pay him Rs. 110 at the end of the year for the Rs
100 loan that Ravi has given to the corporate.
The 10 yield thus translates to Rs 10 of
profits for Ravi.
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Now lets assume that Ravi has an emergency and
needs his money back. For this he goes to the
market and finds his friend John. John realizes
that Ravi needs money urgently. So he offers Ravi
to buy his bond for Rs 90. Ravi, agrees to the
offer and sells the corporate bond for Rs 90.
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At the end of the year John receives the Rs 110
from the corporate. Thus John earns Rs. 20 from
his investment of Rs 90 which he makes when he
buys the corporate bond from Ravi. Thus, Johns
return (which is popularly known as the yield)
works out to 20/90x100 22.2
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Thus while Ravi suffered a loss by selling his
corporate bond at a lower price of Rs 90 instead
of his purchase price of Rs 100 translated into a
gain for John in terms of higher yield which for
him went up from 10 to 22.22.
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Having understood the concept, it will not be
difficult for you to appreciate the inverse
relationship between the price of the bond and
its yield (for the buyer of the bond). i.e. A
bonds yield goes up when its price goes down and
conversely the yield of the bond comes down when
the price of the bond goes up.
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I hope you now have a better conceptual
understanding of the inverse relationship between
the price and yield of a bond and that you
wont have to blindly memorize.
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I will be glad to receive your feedback on this
lesson to understand if there any gaps. Also if
you wish to demystify any other concepts, please
write to me about them. Please send your
feedback to professor_at_tataamc.com
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Disclaimer

• The views expressed in these lessons are for
  information purposes only and do not construe to
  be of any investment, legal or taxation advice.
  They are not indicative of future market trends,
  nor is Tata Asset Management Ltd. attempting to
  predict the same. Reprinting any part of this
  presentation will be at your own risk and Tata
  Asset Management Ltd. will not be liable for the
  consequences of any such action.