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 prices, bond, yield, curve and/or affects:
“United Fruit... United Thieves Company... its a monopoly ... if you wont take their prices they let your limes rot on the wharf; its a monopoly. You boys are working for a bunch of thieves, but I know it aint your fault.”
—John Dos Passos (18961970)
“Every doctor will allow a colleague to decimate a whole countryside sooner than violate the bond of professional etiquet by giving him away.”
—George Bernard Shaw (18561950)
“Hume, and other skeptical innovators, are vain men, and will gratify themselves at any expense. Truth will not afford sufficient food to their vanity; so they have betaken themselves to errour. Truth, Sir, is a cow that will yield such people no more milk, and so they are gone to milk the bull.”
—James Boswell (17401795)
“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 (18861958)
“Never hate your enemies. It affects your judgment.”
—Mario Puzo, U.S. author, screenwriter, and Francis Ford Coppola, U.S. director, screenwriter. Michael Corleone (Al Pacino)