So what’s with bonds then? Well, it’s all a function of interest rates, plus the fact that these bonds tend to be very long term. So the first thing to keep in mind is that once they’ve been issued, they can be bought and sold between other investors, but they’ll stay in force until the maturity date. These can be shorter, say around 2 years, it could be 10 years and the longest US Treasuries have a 30 year term. Now, let's take a look at an example to help illustrate how the relationship between bond prices and yields work. Say the US government issues a 10 year bond with a yield of 3.5%, which is close to what it is right now. You buy $1,000 worth of these bonds which will pay you an income of $35 per year. $1,000 x 3.5% = $35 Say that interest rates go up over the next year and the yield for new 10-Year Treasuries goes up to 5%. Now imagine your friend, let’s call him Gary, wants to buy a 10-Year Treasury bond. Gary can get a newly issued bond with a 5% yield, meaning that his $1,000 investment would pay him $50 per year. You happen to be looking to sell your bonds, so that you can buy some stocks instead. If you try to offload your bond to Gary for the amount you paid for it, he’s probably not going to be interested. After all, his $1,000 for your Treasury bond only gets him $35 per year, whereas a newly issued bond will get him $50. So what do you do? Well, the only way you’re likely to find a buyer for your bond is if you match the yield on offer for new ones. So in this case, you’d have to reduce the purchase price to $700. That’s because $35/$700 = 5%. At a price of $700 on the secondary market, your bond now matches the yield of newly issued bonds and the current market price.
Because of this inverse relationship, bond prices have fallen significantly over the past year or so. The Fed has been massively hiking interest rates in a bid to bring down inflation, and this has meant a major increase in yields.
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