Tuesday, July 5, 2011

Bond Misconceptions

“I keep hearing that bonds aren’t a good investment right now, but bond yields just went up. Doesn’t that mean that the bond naysayers were wrong?” Many investors seem to have a hard time understanding bonds.

In its simplest form a bond is an IOU. Some organization promises to pay you a fixed amount of money on a particular future date. The price of a bond is whatever people are willing to pay for it. If a government bond pays $1000 in a year, you might decide that it’s worth $980 to you. If a small company’s bond pays $1000 in a year, you might decide it’s worth only $900 because the company may not be able to pay.

The bond yield is just the implied interest rate when looking at the bond’s current price, the amount it is supposed to pay, and how long until it pays. So, for the one-year government bond above, the yield is 2.04% (because adding 2.04% to $980 takes it to $1000). However, the small company’s bond pays 11.1% because of the higher risk of default.

The important thing to remember is if bond prices go down, the yield goes up, and if bond prices go up, the yield goes down. So, if you hear that bond yields rose, this may be good for someone about to buy a bond, but it is bad for existing bond-holders because bond prices dropped.

A perverse thing about bond lingo is that it is possible to make every day sound like a good day: either bond prices rise or bond yields rise. Don't be fooled.

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