When investing in bonds, you will often hear the term 'yield.' But what does yield mean?
A bond's yield is influenced by the current market climate, meaning how much investors can demand for lending money to an issuer for a specified period of time. The yield of a bond is also based on the price paid for the bond, its coupon and the bond's term-to-maturity.
When it comes to the price of a bond, this can be impacted by a number of factors, including:
- the creditworthiness of the issuer
- the overall economic outlook and inflation rate and
- changes to interest rates set by central banks.
So, when yields rise, bond prices fall. And when yields fall, bond prices rise.
Let's look at an example: Say an investor buys a bond for one thousand dollars that has a coupon, of six percent, which earns them sixty dollars in interest each year. Since it is bought at par, the yield is the same as the rate of its coupon.
If market yields increase by one percent, new bonds will now offer an interest payment of seven percent -or $70 on one thousand dollars.
Because investors are now able to buy a bond with a higher interest payment- not as many people will want to buy a bond that pays six per cent. The six percent bond's price will fall, causing its yield to rise to seven percent and remain in line with the market.
Another term often used in discussions about bonds is duration.
Duration is a measurement of how sensitive bonds are to changes in interest rates, and is expressed as a number of years.
For example, generally, if a bond has a four-year duration its price would either rise or fall by four percent for every one percent change in yield.
Typically, the further away a bond is from its maturity date, the longer its duration, and the greater the price change could be when yields move. For investors, a good rule of thumb is to invest in bond funds with an overall duration that is equal to their investment time horizon.
But remember, even though bond prices fall when yields rise, your current coupon or interest payments can be reinvested at this new higher rate. Over time, that higher reinvestment rate will help offset the fall in the bond's price.
To learn more about fixed income investing, talk to your financial advisor or visit rbcgam.com.