This articles is from @SahilBloom who is one of the best mentor about finance that willing to share all of his knowledge for free. So if you like the post, please give him a follow and share his lessons.
If you follow the financial news, you see and hear a lot of talk about bonds and bond yields. But what are they and how do they work? Here’s Bonds & Yields 101!
Bonds are a debt funding instrument. The simplest way to think about a bond is that it is a loan given to a company or government by an investor. The entity borrowing money is said to “issue” a bond (i.e. put it up for sale). Investors “buy” the bond, providing a loan.
As with any loan, the investor who purchased the bond is paid interest on the money they loaned and will receive its principal back on a set future date (“maturity date”). The company or government that raised money can now use the funds to support operations or investment.
The perceived “default risk” of the borrower (i.e. the risk of the loan not being repaid) determines the interest rate investors will require as compensation for taking this risk. This rate is called the “coupon” of the bond.
High Risk = High Coupon
Low Risk = Low Coupon
The bond “yield” is just the expected return of owning the bond.
Yield = Coupon Amount / Price Simple
Example: If I pay $1000 for a bond with a $100 annual coupon, that would be a 10% yield ($100 / $1000).
Bonds are tradeable instruments whose prices fluctuate in the open market due to various factors (issuer risk profile, interest rates). As such, bond yields are dynamic.
If I sell that same bond from above for $500, the yield to the new investor would be 20% ($100 / $500).
Bond prices move based on supply and demand. More demand increases the price of the bond, and thus drives down yield (and vice versa).
Yields ⬇️ = Demand ⬆️ Yields ⬆️ = Demand ⬇️
Why should you care? Well, we can learn a lot from the bond market. Treasury bond yields at historic lows? Investors are buying and flocking to safety... Hertz bond yields spiking? It may be in financial trouble...
Current yield and Yield to Maturity
Current Yield is just the return an investor would earn if she purchased a bond and held it for a year.
Current Yield = Annual Coupon / Price
Yield to Maturity ("YTM") is the annual return an investor would earn if she purchased a bond and held it until maturity (when the principal is paid back in full). At issuance, the Current Yield and Yield to Maturity are equal, but they deviate over time.
An example: Say you buy a Hertz bond (don't do this!) that matures in 1 year and has a 10% coupon rate and a $1,000 par value. You pay $800 for the bond.
Current Yield = $100 / $800 = 12.5%
YTM = (Interest+Principal) / Price - 1 YTM = ($100+$1000) / $800 - 1 YTM = 37.5%
Note that the equation becomes more complicated when looking at longer maturities, as you have to discount the future cash flows. We can save that for another thread! Now that we have the basics down, let's take a look at a very relevant (and weird) topic: negative yields.
Negative yields
How do negative yields work? Let's slightly modify our example to illustrate. You buy a US Treasury bond (safe!) that matures in 1 year and has a 1% coupon rate and a $1,000 par value. You pay $1,100 for the bond. YTM = ($10+$1000) / $1,100 - 1 YTM = -8.2% Negative yield!
So negative yields arise when an investor is receiving less money by holding the bond than they paid to purchase it.
An investor is PAYING for the right to loan money - weird!
Why might this happen? ▪️ Flight to safety ▪️ Central Bank "yield curve control" ▪️ Deflation risk
We will see more of this globally in the years to come (hint: buy gold!). While far from comprehensive, I hope this was a helpful primer on the concept of Yield to Maturity and how negative yields may arise in this environment.
This articles is from @SahilBloom who is one of the best mentor about finance that willing to share all of his knowledge for free. So if you like the post, please give him a follow and share his lessons.