Chapter 03 · Currencies, commodities, and government bonds
Bonds and interest rates
A bond is a loan chopped into tradable pieces. The price and the interest rate move in opposite directions. This chapter shows that inverse link with one bond, and then says what a bond still risks besides the rate.
The coupon is not the return
A bond with a face value of ₹1,000, a 7% annual coupon, and three years left, pays ₹70 a year and then ₹1,000, if the issuer pays. If you buy it for exactly ₹1,000, and the issuer pays, your yield is 7%. If you buy it for ₹950, you still receive ₹70 a year, and you also receive a ₹50 gain at maturity if it is redeemed at ₹1,000. Your yield is higher than 7% because you paid less for the same promises. If you buy it for ₹1,050, your yield is lower than 7%. The coupon is the cheque. The yield is the return implied by the price you actually paid.
Why the price falls when rates rise
Suppose new three-year bonds of similar credit start offering 8%. A buyer can get ₹80 a year elsewhere. Your bond’s ₹70 cheque is less attractive, so your bond’s price falls until the buyer of your bond also earns about 8% on the money they spend. You have not missed a coupon. You have lost on the price if you need to sell before maturity. If you hold to maturity and the issuer pays, you still receive the coupons and the face value you were promised; the intermediate price is someone else’s entry yield.
| You bought at | Coupon cheque | If you hold to maturity and the issuer pays | If you must sell after rates have risen |
|---|---|---|---|
| ₹1,000, yield 7% | ₹70 a year | You earn the 7% you locked | You sell below ₹1,000, because new buyers demand a higher yield. |
| ₹950, yield above 7% | ₹70 a year | You earn more than 7%, because of the discount | You may still sell below ₹950 if rates rise further. |
Credit is the other way the promise fails
Everything above assumed the issuer pays. A company can fail to pay. A higher yield on a company bond compared with a government bond of the same length is, in large part, the market’s price for that chance, plus liquidity, plus tax differences. Taking the higher yield and calling it ‘the same as a government bond, only better’ is how credit risk gets smuggled in. The yield gap is the payment for bearing the gap. It is not a free upgrade.
Time makes the price more sensitive
A bond that pays you back next year cannot fall as far, in price, as a bond that pays you back in twenty years, for the same rise in yields. The long bond’s distant cash has to be discounted harder. This is duration, said without the formula: the longer you wait for the bulk of your money, the more the present price swings when the discount rate changes. Matching the bond’s life to the date you need the money is the basic defence. Buying a long bond because the yield is a little higher, when you need the cash in a year, is a rate speculation funded by next year’s fees.
What to remember
- Coupon is the cheque. Yield is what the price you paid implies.
- When market yields rise, existing bond prices fall. When yields fall, prices rise.
- Holding to maturity earns the locked yield only if the issuer pays, and only if you do not need to sell.
- A higher yield than a government bond is payment for credit and liquidity risk.
- Longer bonds move more in price for the same change in rates.