Why Should Investors Care About Bond Yields?

From time to time, bond yields make headlines in the financial press, either because they're going up or because they're going down. Even if you don't own any bonds, it's often wise to pay attention to changes in bond yields. Why? Bond yields can offer hints about where the economy may be headed.

A quick refresher on bonds: When a government or company needs to borrow large sums of money, it issues bonds. Investors buy the bonds, and in return, the issuer promises to pay an annual interest rate (the coupon rate) on the loan, usually in payments every six months. The issuer generally also promises to repay the principal value of the bond (also called face value or par value) on a specific maturity date.

Bonds are a type of fixed-income product. They can generate a predictable stream of interest income and/or promise a future lump-sum payment. Bonds are typically viewed as having less risk than stocks. One key consideration for holding bonds and other fixed-income products in a portfolio is that they can help offset negative returns on other asset classes, helping to reduce overall volatility. (Learn more in Understanding Fixed Income.)

Bond prices and bond yields

A bond price is what an investor pays for a bond. A bond yield is a general term used to describe the return an investor can expect to receive from an investment in a bond. There are a few different types of yields, but a common one you'll see in a quote is Yield to Maturity. Technically, it's based on the bond being held until maturity and the coupon payments reinvested at the yield to maturity interest rate.

Bond prices and yields fluctuate daily, even though a bond's face value, interest rate and maturity are typically fixed. How is that possible? After bonds are issued, investors trade them on the secondary bond market. (The primary market is where securities are created and initially issued; the secondary market is where investors buy or sell previously issued securities.) 

Many factors affect bond prices and yields, including inflation, interest rates and investor demand. The key thing to know is that bond prices and bond yields have an inverse relationship, meaning that they move in opposite directions. When a bond's price increases, its yield decreases; when its price decreases, its yield increases. Here's an example:

• Buying at par: Alex buys a bond with a coupon of 10 percent. If the yield on the bond is also 10 per cent, then Alex would pay par ($100) for the bond. Alex puts up $1,000 to buy the bond which is trading at par.
• Selling at a discount: If interest rates increase or the bond is perceived to be more risky, Alex might only be able to sell the bond at a lower price, say $80. Since the current price is lower than the $100 par value, the bond is considered to be trading at a discount.
• Selling at a premium: If interest rates decrease or the bond is perceived to be safer, Alex might be able to sell the bond higher, say $120. Since the bond price increased above its par value of $100, the bond is considered to be trading at a premium.

Why would someone pay more than face value? Because a bond's interest rate is higher than what the market comparatively offers, or the credit rating of a bond or its issuer makes it an attractive investment.

Even if you don't own bonds and are not planning to buy any, bond yields can give you clues about what's going on in the markets. When bond yields are falling and bond prices are rising, it could indicate an increase in demand for "safe" investments. Investors typically favour bonds when they're looking for a safe place to put their money. If bond yields are rising, that signals bond holders are selling bonds and likely moving money back into the stock market – a sign of optimism for the economy.

The impact of inflation

While bonds are less risky than stocks, they do have risks. One is default risk, which refers to the possibility the issuer of the bond may not be able to make its principal and interest payments. Investors can get an idea of default risk by looking at the issuer's rating (learn more in Types of Fixed Income). Another risk is inflation, which affects bonds in two ways:

1. Rising inflation drives up bond yields. When inflation rises, or is expected to rise, interest rates usually do too, as central banks try to cool down the economy. When this happens, existing bonds fall in price.
2. Rising inflation lowers the purchasing power of a bond's interest payments and principal.

Various asset classes, including fixed income, can play important roles in an investment portfolio. Diversification can help investors protect their portfolios and manage investment risk with a carefully considered asset mix that suits their investment goals and time horizon.

Learn more about inflation.