When the market is going up, prices go up. When the market crashes, prices crash as well. But that's not the whole story. Bonds also have yields, which measure how much an investor gets paid for investing in a company or bond. Since it is natural for yield and price to move in opposite directions, this leaves us wondering why does this happen? Why do two things that are moving in opposite directions also fluctuate in tandem with one another? This article will help answer this question and explain why bonds move in opposite directions.

Basics of Bond Pricing and Yield

Every bond has a coupon, or a rate of return, which is paid to the investor. The coupon is a percentage of the face value (also known as the principal) and is paid periodically, usually semiannually. The face value of a bond is the amount of money that an investor will get back from the company when the bond matures.

The price of a bond is determined by the relationship between the market interest rate and the coupon rate of a specific bond. The higher the interest rate, the higher the price of the bond will be.

Bond Prices and Rates of Return

If interest rates go up, it is more difficult for the company to pay off their debt. If interest rates are low and the company can pay off their debt with a low rate, then the company has a high return on their investment. Now let's look at it from the individual investor's point of view. If the return on investment is high, investors will prefer that investment over a low-risk investment. So, the higher the rate of return, the more investors will pay for that bond. Conversely, when interest rates go down, investors will prefer a lower risk investment over a high risk investment. So, the lower the rate of return, the less an investor is willing to pay for that bond.

How Bonds Move in Opposite Directions: An Overview

Bonds move in opposite directions because of the risk/return trade-off. For every investor, the choice between a high-risk and low-risk investment comes down to the expected return. When interest rates go up, more people want a low-risk investment and would rather have a lower expected return than a high expected return. So, more people want to buy a treasury bond. When interest rates go down, more people want a high-risk investment and are willing to take on a higher expected return than a lower one. So, more people want to buy a corporate bond.

Why Bonds Move in Opposite Directions: An Explanation

Let's start with the Treasury bond. Since this is a low risk investment, buyers expect a low rate of return. But, what happens when interest rates go up? Since Treasury bonds are low risk, the interest rate (yield) on these bonds goes up. This is because when interest rates go up, Treasury bonds become more attractive and investors are willing to pay more for them. On the other hand, let's look at the corporate bond. Since this is a high risk investment, buyers expect a high rate of return. But, what happens when interest rates go down? Since corporate bonds are high risk, the interest rate (yield) on these bonds goes down. This is because when interest rates go down, corporate bonds become less attractive and investors are willing to pay less for them. So, we see that the Treasury bond and the corporate bond move in opposite directions when interest rates change. This is because the expected return of these bonds changes with the interest rate.

Bonds move in opposite directions because of the risk/return trade-off. For every investor, the choice between a high-risk and low-risk investment comes down to the expected return. When interest rates go up, more people want a low-risk investment and would rather have a lower expected return than a high expected return. So, more people want to buy a Treasury bond. When interest rates go down, more people want a high-risk investment and are willing to take on a higher expected return than a lower one. So, more people want to buy a corporate bond.

Additionally, the relationship between bonds and interest rates is not random. It is actually very predictable because it is tied to the overall health of the economy. As the economy improves, interest rates generally increase. If this happens, the price of bonds will fall and the yield will go up. These opposite movements can be seen on the graph above.

Reference used: https://www.investopedia.com/articles/bonds/07/price_yield.asp

Cover image reference: https://img.freepik.com/premium-photo/indian-rupee-neon-sign-glowing-social-networking-iconic-dark-metallic-background-3d-rendering_492780-1242.jpg