What Do Bonds and Yields Mean?

by td0000001

I have noticed that a lot of here can’t read so of course I decided to write up about Bonds. Who cares nobody is going to read it anyways.

A bond is a loan. When you buy a bond from an entity, you are essentially loaning them your money. like any loans, a bond has a face value ( principal) and coupon rate( interest you get for loaning the money until the loan matures). So when I buy a $1000 bond, let say for the face value which is $1000 and a coupon rate of 2%( a year), it means I will get 2% of the principal which is $20 yearly and at the end of the term when it matures I get my principal back.

A bond yield ( there are different ways of calculating this but for the most part you need to know yield to maturity rate) = annual coupon payment / bond price. so for the example above the yield is the same as coupon rate of 2%.

So reading this you might ask yourself that why the yield fluctuates. Referring back to the yield formula above, for yields to go up, either the coupon amount has to increase or the bond price needs to drop. coupon is usually fixed so the only way the yields can go up is for the bond to depreciate in price. Remember regardless of how much you pay for a $1000 bond, you will get the same coupon payment and $1000 principal at the end.

READ  U.S. Yields Hit 2% Could Be Trigger Event Roubini Warns! Central Banks DUMP U.S. Dollar

Imagine you are selling a car and you have a buyer who is willing to pay $9500 and your friend asks you if you would sell the car to her and she will pay you $10000 in a year. Is this a fair deal? In order to answer this question you need to determine how much $10000 a year from now is worth today aka present value(PV) of future cash (FV). This is a fundamental concept in putting a value on an assets(long duration) like stocks or bonds. In simple terms, what you do is to look at the rates for a one year loan and let’s say it is 5%.

PV of $10000 = $10000 / (1+0.05) = $9523

so if you wait a year you get more money for your car.

In the example above, I assumed there was no inflation ( =0). but what if the inflation is 2%? Let’s do the same PV(present value) calculation only considering inflation:

PV + PV*Inflation = $10000 (FV) so PV = 9803.

so now considering both rates ( interest rate + inflation):

PV +PV*interest + PV*inflation = FV -> PV = FV / (1+ inflation+interest).

So going back to the car example and including inflation:

PV = 100000 / (1 + .05+ .02) = $9345.

So, with inflation, now the 9500 offer sounds better than 10000 next year. The higher the inflation, the lower the PV of a future cash flow.

READ  30Y Treasury Auction So Good It Drives Down 30Y Yields And The 30Y-2Y Yield Curve (Mortgage Rates Dropping)

This is the main reason for the all the volatility in the past few weeks. As the inflation fears grow, people start discounting the value of 10 year treasury notes to PV and realizing that it is not worth it to pay as much as last year to buy the bonds because of the fear of erosion in the pv due to an inflation hike and are paying less to buy bonds and that causes the bond yields to go up.

A similar method is used for stock valuation to determine the PV of future cash flows of a company. in this process, an investor determines the PV of the future earnings (cash flow) of a company and based on that calculates a fair price. So for the growth stocks where most of the cash flow is in the future, the the higher the inflation the lower the PV of those cash flows and hence you see multiples on those stocks drop.

So in high inflation environments, value stocks are preferred since a good chunk of their earnings is happening at the present especially the ones with pricing power. i.e. banks, energy, commodities and industrial.

 

1,034 views

Leave a Comment

This site uses Akismet to reduce spam. Learn how your comment data is processed.