10 Yr Tres Bonds - Question

[asphaltgambler]

Why does the yield turn downwards when demand goes up?

[MRM]

The bond has a face value that gets paid to the owner at maturity. So when a new ten year bond is purchased, you pay less than face value for it. The diference between what you paid and the face value at maturity is the interest you earn.

So when the bond gets bought and sold in the secondary market (the bond market, Wall Street, whatever you want to call it) the value of the bond depends on the interest rate people are willing to pay to get the face value of the bond when it matures.

When you pay less than face value you make more in interest. So the price of the bond goes down, but the face value stays the same - the effective interest rate is higher. When you pay closer to face value, you earn less interest - the interest rate is lower.

Basically the more you pay for the bond, the less interest there is to earn, so the interest rate goes down. When bonds cost less to get the face value at a later date, you get a higher return - a higher interest rate.

Clear as mud?

[HardDrive]

The rate on the bond is fixed, but interest rates in the rest of the market are not. So the price of the bond going up and down is a reflection of the future yield given the other options available.

I think I've made it worse.

[TyFenn]

it has been on a bit of a yo-yo ride lately huh?

[jyl]

Simplify it to a hypothetical 1 year bond.

Bond has printed on it "1 year term, $100 face, and 5% coupon". That means in 1 year ("term") you get one payment ("coupon") of $5 (= 5% interest on $100) and you also get the $100 ("face") when the 1 year is up (the bond reaches "maturity").

If you pay exactly $100 for this bond and hold it until maturity, you will get a return ("yield to maturity" or just "yield") of 5.0%. Pay $100, receive $105, 105/100-1 = 0.050

If you pay $97 for this bond, you will get a yield of 8.3%. Pay $97, receive $105, 105/97-1 = 0.083

If you pay $103, you get yield of 1.9%. 105/103-1 = 0.019

So price moves inverse to yield:

$103 1.9%
$100 5.0%
$97 8.3%

For a real life bond, where there are many years of coupon payments which may be semi-annual or some other period, calculating the yield is more complicated, but the principle is the same. For a given bond, the higher the price you pay, the lower the yield you get.

[Rsquared]

All of above is technically correct.

However, the answer is quite simple... it is a function of supply and demand. As demand increases (or supply declines), price goes up. As demand declines (or supply increases), price goes down. In the fixed income market, yield is inversely related to price. Price goes up, yield goes down. Price goes down, yield goes up. See JYL's example above.

So if demand increases, price goes up and yield goes down.

By the way, it's called the fixed income market because of the "fixed coupons" earned on bonds.

[WI wide body]

Also, I'm certainly not a bond expert but I would guess that with the Fed lowering short term interest rates it should make all of the long term bonds (5,10,20,30 year) more valuable.

[asphaltgambler]

Thanks............... it is much clearer to me now