First, you have to understand how bond pricing works, and why the yield on them is inverse to the price. There are many types of bonds, but let’s just focus on a simple 2-year bond issued by the U.S. Government (a 2-year T-Note).
When a T-Note is created, it’s configured at a set price (say $100,000) and pays a set amount of interest (2% for this exercise) for a set period of time (10 years for this one). Once a bond has been issued, at the end of every 6 months the holder of the bond will receive an interest payment based on 2% interest on $100,000 for 6 months which comes out to be $1000. At the end of 10 years the bond is redeemed to the government for the original purchase price of $100,000.
The tricky part is that a $100,000 T-Note doesn’t always sell for $100K. When there is concern about the economy, demand for bonds is higher and someone might be willing to pay $101,000 for our T-Note because they want the security of that 6 month payment versus the volatility of the stock market.
Although the selling price of bonds changes, the interest payment on our bond is always based on 2% on $100,000. Thus, when the price of a bond increases the yield goes down.
More to follow.
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