(PUB) Investing 2015

of the 2% bond holds it to maturity, he gets his 2% per year, plus his money back at maturity, but he’s locked his money in at 2%, when he could have gotten 3% a day later. Yields vs. Interest Rates You’ll notice that I slipped the word “yield” into that last explanation. This difference between interest rates and yields is a key characteristic of bonds that often trips people up. As I explained, a bond’s interest rate or coupon rate is a fixed percentage that describes how much the borrower is paying for lending them money. It’s the rate that is fixed to that particular bond. It never changes. (There are some bonds where the interest rate does change based on other variables, but let’s try to keep this as simple as pos- sible here.) The yield , on the other hand, describes your expected annual total return based on the coupon rate as well as the price you pay for that bond assuming you hold it to maturity. When you buy a bond at par, your yield will be the same as the coupon. To illustrate, let’s go back to my example of the U.S. Treasury issuing identical bonds one day apart with two different coupons, 2% and 3%. When you buy the 3% Treasury at par, you are paying $100 for $100 worth of bonds and can expect to receive $100 at the maturity date. Meanwhile, you will receive $3 in interest each year.

Now let’s pretend that the day after you bought the bond, the U.S. govern- ment realizes it didn’t borrow enough money (imagine that!), so it decides to issue another 10-year bond. However, overnight a report came out indicating that inflation is rising rapidly and prices are going up, up, up. As a consequence, investors immediately begin demand- ing a greater rate of return when lend- ing money. Interest rates rise 1% as soon as the bond markets open, and when the U.S. Treasury offers its new bonds, they have to offer a coupon of 3% rather than the 2% they offered just one day earlier. So ask yourself this question: Which bond would you rather own—the bond paying 3% interest or the one paying 2%? Which bond should have more value to investors? If you could sell your day-old 2% bond for the $100 you paid for it and buy the new 3% bond for $100, you would—it’s the same issuer and has the same maturity (less a day), so there’s basically no difference other than the coupon. But that’s not going to happen. No one will give you $100 for your 2% coupon bond when the same $100 will buy them a bond with a 3% coupon. However, they might be willing to pay less than $100 for the day-old bond. And that’s just what happens. Prices in the bond market adjust (in this case, downward) so that the yield on your day-old 2% bond matches the yield on

and measures of maturity versus dura- tion that the confusion often begins to set in and eyes glaze over, so take this in manageable bites and it will all begin to make sense. The Price-Yield See-Saw Probably the most important thing to understand about bonds is the rela- tionship between prices and yields. If you can remember that these two important components move in dia- metrically opposite directions, you’ll be a long way to understanding much of what you need to know about the bond market. To many, this inverse relation- ship describes interest rate risk , or the risk that a bond’s price will fall if interest rates rise. Most journalists and pundits assume (wrongly, I believe) that everyone understands why that happens. It’s not intuitive, however, so let’s use a simplified example to take a closer look. Let’s say the U.S. government wants to borrow some money. They issue a Treasury bond (or, technically, a Treasury “note” if it will be repaid in less than 10 years, or a “bill” if it’s going to be repaid in as little as three months). On the day of issuance, they agree to pay you 2% a year (the coupon rate) until June 30, 2025 (the maturity date). You buy the bond for $100. At 2%, you will receive $2 a year in interest ($1 every six months, since Treasurys pay semianually) until the maturity date, when you get your last coupon payment and the full $100 face value of the bond back. Your return over the course of the loan will have been 2% a year, the same as the coupon. A quick aside on bond parlance: When a bond is trading at its face value, that’s called par , and it’s expressed in bond price quotes as $100. In our Treasury bond example, the new bond you bought at $100 trades at par, as most newly issued bonds do. At times, new bonds are priced at a premium (above par), and sometimes at a discount (below par), but typically you see bonds trading at premiums and discounts after they have been issued.You’ll see why as I get back to the example, sticking with $100, par-issued bonds.

Bond pricing, yields, maturity and duration can cause confusion to set in and eyes to glaze over, so take it in manageable bites.

the brand new 3% bond. In a nutshell, this is why bond prices fall when inter- est rates rise. (The corollary, of course, is that bond prices rise when interest rates fall.) The investor who purchases a 2% bond at a discount to face value and holds it to maturity will earn the same 3% as the buyer of the new 3% bond. But the original buyer of the 2% bond loses money on the sale. If the buyer

So your yield is 3%, the same as the coupon. But what about the day-old bond with the 2% coupon? No matter wheth- er you buy it on the day it’s offered or one day or one year later, you’ll still get $2 per year from the U.S. Treasury, because that is the contracted (fixed) coupon on that bond. And at the matu- rity date, the U.S. government is still going to pay back the $100 face >

The Independent Adviser for Vanguard Investors • July 2015 • 5

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