Bond yields are a tricky concept for most investors to grasp initially because they are calculated based on a few moving parts and the mainstream media seems to roll back and forth between discussing bond yields and bond prices.
[VIDEO] Understanding Bond Yields
The first, and most important, concept you need to understand when discussing bond yields is that bond prices and bond yields have an inverse correlation. Picture a seesaw with bond prices on one side and bond yields on the other side. When bond prices are going up, bond yields are going down. When bond prices are going down, bond yields are going up. While it may seem counter-intuitive, understanding this relationship will help you avoid a lot of confusion when dealing with bonds.
So How Does It Work?
Bond yields are a measure of the profit you will make from your bond investment. The less you pay for a bond, the greater your profit will be and the higher your yield will be. Conversely, the more you pay for a bond, the smaller your profit will be and the lower your yield will be. If you’re interested in learning How to Calculate Bond Yields, check it out. For now, just understanding the concept is what is important.
Why Should You Care?
You may be thinking to yourself, “I’m not a bond investor. Why should I care what bond yields are doing?” And that’s a fair question. The reason you should care is bond yields are a good indicator of how strong the stock market is and how much interest there is in the US Dollar. If bond yields are going down, it is because bond prices are going up. Now, the only reason bond prices go up is if there is an increase in demand for the bonds.
Typically, you will see an increase in demand for bonds when stock investors are concerned about the safety of their stock investments and they decide to seek more safety for their money by investing in bonds and other US Dollar-backed investments. This will usually cause the USD to rise against the majors.
On the other hand, if bond yields are going up, it is because bond prices are going down. Now, the only reason bond prices go down is if there is a decrease in demand for the bonds. Typically, you will see a decrease in demand for bonds when bond investors feel their money would better serve them if it was invested in the stock market because the stock market is, or is about to, go up. This can actually weaken the dollar.
Image courtesy Horia Varland.