Someone once said to me that a bond price and its yield are the same thing. Really? Let's look at how bond works. Bond has two major components, one is price and the other is yield. As bond price going up, its yield will move to the opposite direction, bond price and bond yield have an inverse relationship.
Most of us have no problem of understanding how stocks work and how to calculate their returns. But for bonds, not so sure. I am going to use the simplistic way to demonstrate how we calculate the return of a bond.
Stock Return = Current Stock Price – the Price Paid for the Stock
Bond Return = (Current Bond Price – the Price Paid for the bond) + the Bond Yield
You will always hear the term called ‘Total Return’, the above examples are the total returns.
The bond yield is fixed at the issuance of the bond. The bond price is determined by the interest rates, the higher the rate, the lower the bond price, and vice versa. There is a term in bond called Duration, which is a weighted average time until bond repayment and a percentage of change in bond price. It is a very important indicator of a bond value. The bond duration is a measure of sensitivity of the price of a bond to a change in interest rate.
For example, a bond with a 20-year duration will goes down 20% for each percentage of an increase of bond interest rate.
As FOMC (Federal Open Market Committee) raises the interest rate, bonds will lose their values. The longer the duration, the bigger drop of the bond value. This means that we should keep our cash in bonds with shorter durations.