How yields work

Before you readCapital at risk. The value of investments and any income from them can fall as well as rise, and you may get back less than you invest. This is information, not advice.

In one paragraphA bond's coupon is fixed, but its price moves. Yield is what the bond pays you as a percentage of what you pay for it today. So when the price goes down, the yield goes up, and when the price goes up, the yield goes down. They always move in opposite directions.

Three numbers describe every bond: the coupon, the price and the yield. They are easy to confuse, and most of the bond market makes sense once they are separate in your mind.

First, try the arithmetic

Change the underlined words in the sentence below. It shows the coupon side of a bond: what a loan pays if the borrower keeps every promise and you hold it to the end.

Coupon, price and yield: what is the difference?

• The coupon is the interest the bond pays, fixed when it is first sold. In the example, £50 a year. It never changes.
• The price is what someone will pay for the bond today. It changes every day.
• The yield is the coupon as a percentage of today's price. Pay £1,000 for £50 a year and the yield is 5%. Pay less and the yield is higher. Pay more and it is lower.

Why do bond prices fall when interest rates rise?

Imagine you hold the £1,000 bond paying £50 a year. A year later, new bonds of the same kind pay 6%, or £60 a year on £1,000. Nobody will pay you £1,000 for £50 a year when they can get £60 elsewhere. To sell, you have to accept a lower price, low enough that your £50 looks as good as their £60.

The same works in reverse. If new bonds pay only 4%, your £50 a year is worth more, and buyers will pay more than £1,000 for it.

If you do not sell, none of this changes what you are paid. You still receive £50 a year and £1,000 at the end, if the borrower keeps its promise. Price only matters if you sell, or if you hold a fund whose value is worked out from today's prices.

Is yield the same as return?

No. Yield is a snapshot: what a bond pays relative to its price today. Return is what you actually end up with, which depends on the price you buy at, the price you sell at or the repayment you receive, the interest you collect, and whether the borrower pays. Yield is not return, and a high yield is not a promise of a high return.

What is yield to maturity?

If you buy a bond below its face value, you get the interest and also a gain when it repays in full. Yield to maturity rolls both into one figure: the yearly return if you buy at today's price, hold to the end, and every payment is made on time. It is the most useful single figure for comparing bonds, as long as you remember the "if".

Why is there no single interest rate?

You will hear "interest rates are rising" as if there were one rate. There are many, and they answer different questions.

• Bank Rate is set by the Bank of England. It is the rate for overnight money between banks, and it moves when the Bank decides.
• Two-year gilt yields move with what lenders expect Bank Rate to do over the next two years.
• Mortgage fixes follow what lenders pay to borrow for two, five or ten years, which moves with the bond market, not with Bank Rate alone.
• Thirty-year gilt yields reflect a long view: inflation over decades, how much the government will need to borrow, and how much long-term lending pension funds and insurers want.

These can move in different directions on the same day. Bank Rate can be cut while thirty-year gilt yields rise, if lenders worry about the long term.

What is duration?

Duration measures how sensitive a bond's price is to changes in interest rates. The longer a bond has left to run, the higher its duration, and the more its price moves. As a rough guide, a bond with a duration of 10 would fall by about 10% if yields rose by one percentage point, and rise by about 10% if they fell by one. That is an approximation, not a rule.

What does the yield curve show?

Line up the yields on loans with different maturity dates to the same borrower, from a few months to thirty years, and you get the yield curve. Usually it slopes upwards: lenders want more for tying up their money for longer. Its shape changes with what lenders expect for interest rates and inflation. Sometimes it is flat, and occasionally short loans pay more than long ones.

Rising rates are one of the two big forces that move bond prices. The other is inflation, and chapter VII shows how they work together.

You now have every piece you need to compare owning one bond with owning a fund of many. That is the next chapter.