Peak Rates: How to Benefit from Bond Price & Yield

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Alex Frank

the concept of US treasury bonds in the style of Thomas Hart Benton

U.S. Treasury Bonds have long been considered a cornerstone of stability and security. However, with the recent signals suggesting that we’ve reached peak interest rates, these bonds are now presenting an interesting opportunity for investors. I’d like to share some educational insights into why this might be an opportune moment to consider Treasury Bonds.

The Dual Upside of Treasury Bonds

One of the most intriguing aspects of Treasury Bonds in the current economic landscape is their dual upside. Firstly, these bonds offer a yield for holding them, which is a regular interest payment to the bondholder. This yield is especially attractive in a high-interest-rate environment, as it translates to higher income for investors.

But there’s another side to this coin. When interest rates fall from their peak, as they inevitably do in the cyclical nature of economies, the market price of existing bonds with higher rates increases. This appreciation in bond prices can lead to significant capital gains for investors holding onto their bonds. In essence, investors benefit both from the regular income and the potential increase in the bond price.

Risks and Considerations

It’s crucial, however, to understand the risks involved. The primary risk in bond investing is interest rate risk. If interest rates rise further instead of falling, the market value of the bonds will decline. This can be particularly impactful for long-term bonds, which are more sensitive to interest rate changes.

Inflation also poses a risk, as it can erode the purchasing power of the fixed income from the bond. In a high-inflation environment, the real return on bonds can be significantly diminished.

Moreover, while U.S. Treasury Bonds are backed by the full faith and credit of the U.S. government, making them virtually risk-free in terms of credit risk, they are not immune to market dynamics and global economic factors.

A Real-World Example

Consider this scenario: An investor purchases $10,000 worth of 10-year U.S. Treasury Bonds when the yield is at its peak, say 5.25%. Over the next 2 years, the interest rates fall and new bonds will be issued at a 3.5% yield. The bond’s market value will increase. Let’s calculate by how much.

The Bond Price Formula

The formula to calculate the market value of a bond can be intimidating i.e.

image 3
Bond price formula

Where:

  • C = Coupon Rate
  • FV = Face Value
  • r = Yield to Maturity (YTM)
  • n = Coupon Frequency i.e. Number of Coupon Payments Per Year
  • t = Years to Maturity
  • PMT = Periodic Interest Payments

Calculating the Bond Price

Instead of doing this manually let’s use an online calculator. We calculate the following when we plug in our example data points:

  1. The price to purchase the bond is now $11,202.94
  2. The annual coupon (interest payment) is $525.00

Here are step-by-step instructions to calculate the bond price:

image 5

The market price for this bond is higher because the bond’s higher interest rate makes it more attractive than new bonds with lower yields. Consequently, the investor benefits from the higher yield income and can also sell the bond at a premium if they choose to liquidate their investment. The breakdown of payments is shown below.

Chart representing present value of bond payments

The Inverse Relationship Between Bond Yield and Bond Price

The main reason that bond prices and yields are inversely correlated is that bond investors are risk-averse and will require a higher yield to compensate for a greater risk of loss. When interest rates rise, investors can earn a higher return on newly issued bonds. As a result, they will be less willing to buy existing bonds that have lower yields. This drives down the prices of existing bonds, which in turn increases their yields.

Chart of the inverse relationship of bond price and bond yield

Conversely, when interest rates fall, investors can earn a lower return on newly issued bonds. As a result, they will be more willing to buy existing bonds that have higher yields. This drives up the prices of existing bonds, which in turn decreases their yields.

Closing Remarks

In summary, while U.S. Treasury Bonds present a unique opportunity in the current economic climate, investors need to weigh the potential rewards against the risks. Understanding these dynamics and keeping a close eye on interest rate trends and economic indicators is key to making informed investment decisions. As always, diversification and a thorough risk assessment tailored to individual investment goals and horizons should guide any investment strategy.

Disclaimer

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