Understanding the Inverse Relationship between Bond Prices & Yields

Why do bond yields go up

when bond prices go down?

You might have come across a set rule which states, When bond prices goes down, bond yield goes up & vice versa.
This rule is then simply memorized and never questioned. Memorizing without questioning makes concepts dull and boring but understanding, on the other hand, makes concepts come alive.

I am sure you will agree that when the seller of a good sells at a lower cost, he makes a lower profit. However, in the same deal the purchaser of the good makes a gain due to the attractive price of purchase.

Hence when a seller of a bond sells it at a reduced price, while he loses, the buyer of the bond gains from the transaction.

Thus the loss for the seller is the fall in price while the gain for the buyer is the benefit of higher yields.

Now lets understand with a simple example. Lets assume that Ravi has a corporate bond of Rs 100 which is to give him 10% returns per annum. In other words, the company would pay him Rs. 110 at the end of the year for the Rs 100 loan that Ravi has given to the corporate. The 10% yield thus translates to Rs 10 of profits for Ravi.

Now lets assume that Ravi has an emergency and needs his money back. For this he goes to the market and finds his friend John. John realizes that Ravi needs money urgently. So he offers Ravi to buy his bond for Rs 90. Ravi, agrees to the offer and sells the corporate bond for Rs 90.

At the end of the year John receives the Rs 110 from the corporate. Thus John earns Rs. 20 from his investment of Rs 90 which he makes when he buys the corporate bond from Ravi. Thus, Johns % return (which is popularly known as the yield) works out to: {20/90}x100 = 22.2%

Thus while Ravi suffered a loss by selling his corporate bond at a lower price of Rs 90 instead of his purchase price of Rs 100 translated into a gain for John in terms of higher yield which for him went up from 10% to 22.22%.

Having understood the concept, it will not be difficult for you to appreciate the inverse relationship between the price of the bond and its yield (for the buyer of the bond). i.e. A bonds yield goes up when its price goes down and conversely the yield of the bond comes down when the price of the bond goes up.

I hope you now have a better conceptual understanding of the inverse relationship between the price and yield of a bond and that you wont have to blindly memorize.