Bond prices are used as a
benchmark for forecasting the macro economic environment, interest rates, and
forecasting future interest rate trends. Understanding bond prices and yields
are important for investors, but also understanding bond quotes is a part of
this and how inflation plays into the process.
Below is a table of
United States Rates and Bonds, taken from Bloomberg markets
Treasury Yields
Name
|
Coupon
|
Price
|
Yield
|
1
Month
|
1
Year
|
Time
(EDT)
|
GB3:GOV
3
Month
|
0.00
|
0.09
|
0.17%
|
-12
|
+17
|
2:44
PM
|
GB6:GOV
6
Month
|
0.00
|
0.37
|
0.39%
|
-5
|
+29
|
2:45
PM
|
GB12:GOV
12
Month
|
0.00
|
0.58
|
0.59%
|
+1
|
+25
|
2:45
PM
|
GT2:GOV
2 Year
|
0.75
|
99.95
|
0.78%
|
+4
|
+10
|
2:45 PM
|
GT5:GOV
5
Year
|
1.13
|
99.73
|
1.18%
|
+4
|
-25
|
2:44
PM
|
GT10:GOV
10
Year
|
1.50
|
98.75
|
1.64%
|
+9
|
-50
|
2:45
PM
|
GT30:GOV
30
Year
|
2.25
|
97.69
|
2.36%
|
+12
|
-59
|
2:45
PM
|
The first thing to point out is
that a bond’s price (third column) is made up of a “handle” and “32s”. So, let
us take the two year government bond. We see that the price is 99.73, or that
the handle is 99 and the 73 is the 32’s. To understand what this means we have
to do some math and convert these numbers so as to determine how much this bond
is worth. First divide 95/32 = 2.9687. We then add this number to 99 (99+
2.9687), which equals 101.9687. So 99.95 equals 101.9687% of the par value of
$100,000, or $101,9687.
This dollar price represents a
percentage as we saw above of the bond’s principle balance, also known as the par value. Since a bond
is a loan the par value is the loan amount. The example that we chose, the two
year government bond, is trading above par value, or $101, 968. If the bond was
trading at $100,000 then it would be trading at par value.
Bonds not only pay the amount at
the end of maturity, they also pay coupon payments, either monthly or
quarterly.
Now a question arises as to when
and why would someone pay more for a bond, that is more that the par value.
Bond prices are sensitive to interest rates, so when a bond pays a higher
coupon rate on a bond, that the current market rates, it is reasonable to pay
more for that bond. That is to say, the investor, provided he holds that bond
until maturity, will receive coupon payments (interest payments) greater than
what the market currently pays for equivalent investments. Similarly, for a
bond that is priced at a discount, it is because the coupon payments are below
the current market rates.
A bond consists of cash flows that
is the principal amount at the end of the bond’s maturity, and the coupon
payments, which are either monthly, quarterly, depending on the bond. A bond’s
yield (fourth column above in the table), relates a bond’s price to its cash
flows. This yield is the discount rate that can be applied to make the present
value of a bond’s cash flows to its price. It is the amount of return an
investor realizes. As bond prices rise,
bond yields fall. In our example in the table above of the two year bond, the
coupon is 0.75 and the price of the bond is $101.968, so 0.75/101.968 equals
$76.47, which is the amount of interest the bond pays annually.
Its annual yield is the interest
divided by par, or in this case above par or $76.47/$101.968, which equals
0.75, the coupon payment.
A bond’s yield is inversely related
to its price so when inflation expectations rise so do interest rates, which
actually decreases the money supply, and the discount rate used to calculate
the bond’s price increases, making the price of the bond fall. Simply put, when
interest rates rise, prices of bonds fall. When the economy is at a recovery,
interest rates fall, and bond prices rise.
So inflation expectations is the
key influencing variable in determining discount rates which are used to
calculate the price of a bond. Notice in the table of bonds above that each
bond has a different yield, and as the maturity gets longer, the higher the
yield. The longer is the bond’s maturity, the greater the risk. One such risk
could be the risk of higher inflation, so investors would want to be
compensated for the risk and the price they are willing to pay for the bond.
So prices of bonds and yields are
an excellent predictor of the state of the economy in the future. To see the
market’s prediction of future of the economy, one has to look at the yield
curve. The yield curve plots interest rates with different maturities. The
shape of the yield curve (the steepness) gives an idea of future interest rates
changes. There are three main yield curves: normal, inverted and flat.
A normal yield curve is an up slope
curve, an indication that bonds with longer maturities bonds have higher
yields. An inverted, is a down slope yield curve. It indicates that short term
yields are higher than long term, and a sign of an upcoming recession, and a
flat, is one where yields on long term maturity bonds are rising, and yields on
short term bonds are falling.
Below is a nice graph from the
European Central Bank, the Euro area yield curve, date 21 September 2016, for
AAA rated bonds.
Below is a chart of the US Treasury
Bond Rates from Yahoo Finance, September 22, 2016.
US Treasury Bonds Rates
|
||||
Maturity
|
Yield
|
Yesterday
|
Last
Week
|
Last
Month
|
3 Month
|
0.15
|
0.18
|
0.26
|
0.27
|
6 Month
|
0.35
|
0.37
|
0.44
|
0.41
|
2 Year
|
0.74
|
0.75
|
0.70
|
0.71
|
3 Year
|
0.87
|
0.89
|
0.84
|
0.84
|
5 Year
|
1.14
|
1.17
|
1.16
|
1.11
|
10 Year
|
1.60
|
1.63
|
1.67
|
1.53
|
30 Year
|
2.32
|
2.36
|
2.44
|
2.20
|
Notice the Treasury bond rates
above as the maturity increases, say from 6 months to two years, the yield
increases. The yield refers to the yield a bond provides based on its market
price and coupon rate.
