How The Yield Curve Affects Bond Prices
There is a time dimension to the analysis of bond values. A 10-year bond at purchase becomes a 9-year bond a year later, and the year after it becomes an 8-year bond, etc. Each year the bond moves incrementally closer to maturity, resulting in lower volatility and shorter duration and demanding a lower interest rate when the yield curve is rising. Since falling rates create increasing prices, the value of a bond initially will rise as the lower rates of the shorter maturity become its new market rate. Because a bond is always anchored by its final maturity, the price at some point must change direction and fall to par value at redemption.
A bond's market value at different times in its life can be calculated. When the yield curve is steep, the bond is predicted to have a large capital gain in the first years before falling in price later. When the yield curve is flat, the capital gain is predicted to be much less, and there is little variability in the bond's total returns over time.
Rising (or falling) interest rates rarely rise by the same amount all along the yield curve—the curve rarely moves up in parallel. Because longer-term bonds have a larger duration, a rise in rates will cause a larger capital loss for them, than for short-term bonds. But almost always, the long maturity's rate will change much less, flattening the yield curve. The greater change in rates at the short end will offset to some extent the advantage provided by the shorter bond's lower duration.
The yearly 'total return' from the bond is a) the sum of the coupon's yield plus b) the capital gain from the changing valuation as it slides down the yield curve and c) any capital gain or loss from changing interest rates at that point in the yield curve.
Read more about this topic: Yield Curve
Famous quotes containing the words yield, curve, affects, bond and/or prices:
“The important question is not, what will yield to man a few scattered pleasures, but what will render his life happy on the whole amount.”
—Joseph Addison (1672–1719)
“I have been photographing our toilet, that glossy enameled receptacle of extraordinary beauty.... Here was every sensuous curve of the “human figure divine” but minus the imperfections. Never did the Greeks reach a more significant consummation to their culture, and it somehow reminded me, in the glory of its chaste convulsions and in its swelling, sweeping, forward movement of finely progressing contours, of the Victory of Samothrace.”
—Edward Weston (1886–1958)
“Censorship is never over for those who have experienced it. It is a brand on the imagination that affects the individual who has suffered it, forever.”
—Nadine Gordimer (b. 1923)
“The principle of subordination is the great bond of union and harmony through the universe.”
—Catherine E. Beecher (1800–1878)
“To expect to increase prices and then to maintain them at a higher level by means of a plan which must of necessity increase production while decreasing consumption is to fly in the face of an economic law as well established as any law of nature.”
—Calvin Coolidge (1872–1933)