Bond prices drop but their yields go up??

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edvest
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Bond prices drop but their yields go up??

Post by edvest » Thu Nov 01, 2018 6:14 am

"Adding to the stock market's anxieties has been a rare simultaneous drop in bond prices that pushed yields near their highest levels in years."
Excerpt page one, today's WSJ 11/1/18, "October's Wild Ride Jolts Investors"

Excerpt same story page A10
"Concern that the U.S. economy is on the verge of overheating pushed up bond yields, inducing the stock market's first bout of volatility earlier in the month as investors were forced to rethink the rich valuations in some pockets of the equities market.

I don't get it. Bond prices go down and their yields go up?

Jags4186
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Re: Bond prices drop but their yields go up??

Post by Jags4186 » Thu Nov 01, 2018 6:25 am

If you have a bond with a face value of $100 that pays a 10% yield it is paying $10 a year in interest.

If prevailing interest rates move up and a new bond is paying a 20% yield, you can buy a face value $50 bond to get your same $10 in interest.

What happens to the $100 bond paying 10%? It’s market value has decreased from $100 to $50 as to get someone to purchase that bond from you you would need to be able to match the interest rate of new issue bonds.

When yields rise, the market value of bonds fall.
Last edited by Jags4186 on Thu Nov 01, 2018 6:27 am, edited 1 time in total.

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Re: Bond prices drop but their yields go up??

Post by beyou » Thu Nov 01, 2018 6:26 am

Yes that is true.
The income in $ you earn on existing bonds would not change. Think of yield as the ratio of the annual $ income to the $ value of your bond(s). If the numerator is the same but the denominator is lower, the ratio is higher. Conversely, if the price/market value rises, the ratio or yield declines. For any fixed rate bond the annual $ income does not change, only the relate % of the value of your bonds can change.

Think of yield as the % you receive if you bought the bond today at today’s prices. So reduced prices offer the buyer a better yield going forward. The existing bond holder loses value but going forward earns that yield on the now reduced value of their holdings.

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Re: Bond prices drop but their yields go up??

Post by Valuethinker » Thu Nov 01, 2018 6:28 am

edvest wrote:
Thu Nov 01, 2018 6:14 am
"Adding to the stock market's anxieties has been a rare simultaneous drop in bond prices that pushed yields near their highest levels in years."
Excerpt page one, today's WSJ 11/1/18, "October's Wild Ride Jolts Investors"

Excerpt same story page A10
"Concern that the U.S. economy is on the verge of overheating pushed up bond yields, inducing the stock market's first bout of volatility earlier in the month as investors were forced to rethink the rich valuations in some pockets of the equities market.

I don't get it. Bond prices go down and their yields go up?
If you pay $100 for a 10 year bond that pays a 5% coupon it will pay you $5 per year, and $100 at maturity. Your Yield To Maturity will be 5%.

If you pay $110 for this bond, it will still pay you $50 in coupons, and you will lose -$10 when it matures at $100. Thus your YTM will be less than 5%. Say 4.5%. YTM takes into account both the coupon and the capital/ gain or loss at redemption/ maturity.

If you pay $90 for this bond, your return will be the $50 of coupons but also +$10 capital gains at maturity (income tax treatment of that is usually as interest). Thus your YTM will be c. 5.5%

The point is the coupons and the maturity amount, and the time to maturity are fixed. The Yield To Maturity thus flexes in the opposite direction to the price of the bond. Bond price at a premium to par (maturity) value => yield discount. Bond price at a discount to par => yield premium relative to the coupon.

Price and Yield To Maturity are on a seesaw (or teeter totter) if you will - prices fall, yields rise. Prices rise, yields fall.

The actual math is fiddly because we buy bonds between the coupon dates. But the computer works it out for us. Technically it is the Internal Rate of Return of the bond cash flows to the investor (including the outflow at the beginning to pay for the bond).
Last edited by Valuethinker on Thu Nov 01, 2018 6:29 am, edited 1 time in total.

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BeBH65
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Re: Bond prices drop but their yields go up??

Post by BeBH65 » Thu Nov 01, 2018 6:29 am

We have a number of wiki articles on bonds: for instance Bonds_pricing_on_the_secondary_market
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Re: Bond prices drop but their yields go up??

Post by Grt2bOutdoors » Thu Nov 01, 2018 6:29 am

Imagine you hold a ten year Treasury note with a par value of $1,000 and a coupon of 3%. The bond price declines to $985 on the open market and the coupon remains fixed at 3%. What is the yield? The yield is the coupon rate divided by the price paid or 3.05%. The yield has risen by 5 basis points.
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Re: Bond prices drop but their yields go up??

Post by Grt2bOutdoors » Thu Nov 01, 2018 6:30 am

Valuethinker wrote:
Thu Nov 01, 2018 6:28 am
edvest wrote:
Thu Nov 01, 2018 6:14 am
"Adding to the stock market's anxieties has been a rare simultaneous drop in bond prices that pushed yields near their highest levels in years."
Excerpt page one, today's WSJ 11/1/18, "October's Wild Ride Jolts Investors"

Excerpt same story page A10
"Concern that the U.S. economy is on the verge of overheating pushed up bond yields, inducing the stock market's first bout of volatility earlier in the month as investors were forced to rethink the rich valuations in some pockets of the equities market.

I don't get it. Bond prices go down and their yields go up?
If you pay $100 for a 10 year bond that pays a 5% coupon it will pay you $5 per year, and $100 at maturity. Your Yield To Maturity will be 5%.

If you pay $110 for this bond, it will still pay you $50 in coupons, and you will lose -$10 when it matures at $100. Thus your YTM will be less than 5%. Say 4.5%. YTM takes into account both the coupon and the capital/ gain or loss at redemption/ maturity.

If you pay $90 for this bond, your return will be the $50 of coupons but also +$10 capital gains at maturity (income tax treatment of that is usually as interest). Thus your YTM will be c. 5.5%

The point is the coupons and the maturity amount, and the time to maturity are fixed. The Yield To Maturity thus flexes in the opposite direction to the price of the bond. Bond price at a premium to par (maturity) value => yield discount. Bond price at a discount to par => yield premium relative to the coupon.

Price and Yield To Maturity are on a seesaw (or teeter totter) if you will - prices fall, yields rise. Prices rise, yields fall.

The actual math is fiddly because we buy bonds between the coupon dates. But the computer works it out for us. Technically it is the Internal Rate of Return of the bond cash flows to the investor (including the outflow at the beginning to pay for the bond).
+1 - a more detailed explanation.
"One should invest based on their need, ability and willingness to take risk - Larry Swedroe" Asking Portfolio Questions

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Re: Bond prices drop but their yields go up??

Post by edvest » Thu Nov 01, 2018 6:52 am

Thanks guys, it seems embarrassingly simple now.
I spent most of life thinking about my industry/job..., maybe not the biggest mistake but a mistake nevertheless.

Thanks again! :happy

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Re: Bond prices drop but their yields go up??

Post by nisiprius » Thu Nov 01, 2018 7:05 am

The reason for this is that unlike stocks, a bond is a legal contract and (usually) calls for specific numbers of dollars to be paid out on specific days. The payments are fixed (hence "fixed income") and have nothing to do with the market value of the bond.

If the market value of a bond drops, the payments stay the same. At issue, you might buy a bond for its face value of $1000 (± some small "premium" or "discount"). Each semiannual "coupon payments" might be 1% of the face value. If you buy it on the market at a lower price, the coupon payments are worth more than 1% of the price you paid for them. Hence, when a bond value drops, its yield rises.

This is different from stocks, where there's a similar relationship but it is only a vague and unreliable "tends-to." Stock dividend payments are governed by the stock issuer's business situation and market conditions. If the price of a stock drops, it may well be because the earnings of the company have dropped, and the dividend payments will probably drop sooner or later (as just happened in a dramatic way with GE).

Unfortunately, bond math is precise and inexorable. The reason why the price of the old bond dropped, and the yield increased, is because interest rates have risen and you can now buy fresh, new bonds that that pay higher (contractually fixed) numbers of dollars semiannually. The price of your bond has dropped to make it exactly competitive with newly issued bonds; and by bond math it is no better or worse an investment than it was before.

The calculations are complicated by the fact that (most) bonds pay back their face value at maturity. The series of payments from a "2%" bond look approximately like $10, $10, $10, $10, $10, $1010 (with the face value being paid out together with the last interest payment). The series of payments from a "4%" bond might be approximately $20, $20, $20, $20, $20, $1020. Although the interest being paid out is double, the total amount paid out by the bond is dominated by that last big payment, so--using those play numbers literally--the 2% bond pays out a total of $1060, the 4% bond $1120, which is nowhere near twice as much. So when the interest rate doubles, the market value of an old bond isn't cut in half, it drops by a much smaller percentage.
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Re: Bond prices drop but their yields go up??

Post by Valuethinker » Thu Nov 01, 2018 7:49 am

edvest wrote:
Thu Nov 01, 2018 6:52 am
Thanks guys, it seems embarrassingly simple now.
I spent most of life thinking about my industry/job..., maybe not the biggest mistake but a mistake nevertheless.

Thanks again! :happy
Actually it's part of the philosophy here.

Focus on what you can control: your income and career (to an extent), your expenses & savings rate, the costs of fund management to you (expense ratios). Your hobbies and pastimes - how you spend your time.

Know what you cannot control : the returns of bonds & equity funds.

Then set an asset allocation what works for you in terms of risk/ volatility (in a simple 2, 3 or 4 index fund portfolio) and then invest it, rebalance periodically and concentrate on the rest of your life.

It doesn't really change your life if you know that prices & yields of bonds move in opposite directions. It's nice to know, it helps one read the financial press. But all you really care about is the total return on your stock and bond funds.

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Re: Bond prices drop but their yields go up??

Post by aristotelian » Thu Nov 01, 2018 8:25 am

OP, you might check out a good book on bonds, as they are not nearly as intuitive as stocks. There are also more kinds with different risks than stocks. I Bonds, Treasuries, and Junk Bonds behave way more differently than small vs large or growth vs value, for example. Also, while stocks go up or down based on how the company performs, bonds go up or down based on how the world around them changes (since the bond itself holds constant). I learned a lot from Larry Swedroe's book, The Only Winning Bond Strategy You'll Ever Need.

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Re: Bond prices drop but their yields go up??

Post by grabiner » Fri Nov 02, 2018 10:26 pm

To understand this relation, look for the "duration" of your bond fund. This is a measure of how much rates will change. If a bond fund has a 5-year duration, and the yields on bonds in that fund rise by 1%, the fund will lose 5% of its value. (The reason that duration is measured in years is that this is the break-even time; since yields rose by 1%, you will make 1% more per year on the bonds in the future, so that if rates don't change again, you will be in the same place in 5 years as if the yield hadn't changed.)
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edvest
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Re: Bond prices drop but their yields go up??

Post by edvest » Sun Nov 04, 2018 8:58 am

Thanks for all the help, and I will be getting Swedroe's book.

Another question:
My 401K offers two bond funds. VTBLX, Vanguard Total Bond Market, and WTRIX Wells Fargo Core Bond.

The first has a turnover rate of 55% while the later is 542%!

Can anyone explain this?

Thanks again!

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Re: Bond prices drop but their yields go up??

Post by Valuethinker » Sun Nov 04, 2018 10:37 am

edvest wrote:
Sun Nov 04, 2018 8:58 am
Thanks for all the help, and I will be getting Swedroe's book.

Another question:
My 401K offers two bond funds. VTBLX, Vanguard Total Bond Market, and WTRIX Wells Fargo Core Bond.

The first has a turnover rate of 55% while the later is 542%!

Can anyone explain this?

Thanks again!
A passively managed fund like the Vanguard fund will only trade bonds when it has to. Typically if they have less than 1 year to mature they are sold OR they are held to maturity. Otherwise new bonds are bought when old bonds mature, and bonds are bought (or sold) when there are inflows (or outflows) from the fund.

(Confusingly, by a strict definition, TBM is an "active" fund. Rather than slavishly following a specific index, Vanguard feels it is actually better to construct a portfolio with *around* the characteristics of the index, but without having to hold many bonds in the index which are of low liquidity, or to be heavily weighted towards part of the bond market (like US govt mortgage backed securities) which they find to be unattractive (on objective, quantitative grounds***). For practical purposes, you can treat it like an index fund -- it has appealingly low costs**).

By contrast an actively managed fund will try to beat its benchmark, by trading bonds that are too cheap/ too expensive in the view of the fund manager.

However bonds have a bid-ask spread. You sell at the lower price (the bid) and buy at the higher price (the ask) -- even institutional fund managers buying and selling in millions every day pay that spread. Even though this spread is likely only a few 10ths or 100ths of a per cent of the actual price, it's enough to cause a real drag on performance if the fund turns over too much. Meaning the fund manager must make greater bets to try to claw that back.

You definitely should prefer a bond fund with lower turnover. DFA for example, makes sure that its clients are not the types to try to trade mutual funds, and thus they can reduce transactions costs in the fund (and invest in less liquid bonds, ie bigger bid-ask spreads, which may be attractive for other reasons). But you pay a load for DFA funds through a financial adviser, so in practice TBM has done a perfectly good job of serving the needs of 90%+ of investors.

** for technical reasons, Larry Swedroe does not like it. It holds US government mortgage backed securities, and it holds investment grade corporate bonds (ie not sub investment grade or high yield or "junk" bonds). Both of these securities come with their own types of risk.

The reality is for the vast majority of Boglehead investors, Swedroe's arguments (which are logically correct and well founded) don't need to worry about it. Own TBM, invest regularly, rebalance periodically, and don't get too worked up about 1-2% the wrong way at various times (performance for the whole fund).

*** for example they avoid "callable" corporate bonds, I believe. Where the borrower has the right to repay the bond early if interest rates drop (bonds trade over par).

Vanguard did blow it once with this fund-- I vaguely recall. Worldcom, the largest corporate bankruptcy in history, in the early 2000s. They had too many Worldcom bonds (which had been rated investment grade by the credit rating agencies only a few months earlier) and the company declared bankruptcy after revelations of persistent accounting fraud. Normally when a bond gets downgraded below IG (BBB- on the S&P scale) the fund will just sell the bonds. But there was not the time/ liquidity to do that, so Vanguard became a creditor in bankruptcy. I think the fund lost something like 1-2% of NAV right there, which is a lot for an investment grade bond fund to lose.

I believe they learned from this disaster about concentration of risk in the bonds of one or a small group of issuers. They are more diversified now.

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Re: Bond prices drop but their yields go up??

Post by Scrapr » Sun Nov 04, 2018 11:51 am

Let me ask this. I understand individual bonds go up & down in value with interest rates. Now bond funds do not have a fixed end date. The bond fund owns lots of bonds

I look at my Vanguard Total Bond Fund and see it has gone down approx 10% in value. Balanced by the increase in dividends. Is the 10% decrease reflecting the increasing dividends? Vanguard is down this weekend for repairs.....errr maintenance or I would try to calculate it. Off the top of my head I think the dividend has increased by approx 10%.

So shouldn't the return calculated by VG YTD be closer to zero? Instead of neg 10%?

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Re: Bond prices drop but their yields go up??

Post by patrick » Sun Nov 04, 2018 12:14 pm

Scrapr wrote:
Sun Nov 04, 2018 11:51 am
Let me ask this. I understand individual bonds go up & down in value with interest rates. Now bond funds do not have a fixed end date. The bond fund owns lots of bonds

I look at my Vanguard Total Bond Fund and see it has gone down approx 10% in value. Balanced by the increase in dividends. Is the 10% decrease reflecting the increasing dividends? Vanguard is down this weekend for repairs.....errr maintenance or I would try to calculate it. Off the top of my head I think the dividend has increased by approx 10%.

So shouldn't the return calculated by VG YTD be closer to zero? Instead of neg 10%?
The price of Vanguard Total Bond is down by about 4.9% YTD. The total return, including dividends, is down by about 2.7%. The increased yield will eventually make up for the price decline but it doesn't happen immediately (and is complicated by future interest rate changes).

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Re: Bond prices drop but their yields go up??

Post by grabiner » Sun Nov 04, 2018 12:39 pm

Scrapr wrote:
Sun Nov 04, 2018 11:51 am
Let me ask this. I understand individual bonds go up & down in value with interest rates. Now bond funds do not have a fixed end date. The bond fund owns lots of bonds

I look at my Vanguard Total Bond Fund and see it has gone down approx 10% in value. Balanced by the increase in dividends. Is the 10% decrease reflecting the increasing dividends? Vanguard is down this weekend for repairs.....errr maintenance or I would try to calculate it. Off the top of my head I think the dividend has increased by approx 10%.

So shouldn't the return calculated by VG YTD be closer to zero? Instead of neg 10%?
The SEC yield, not the dividend yield, is the yield which rises when prices fall. The dividend payment of a bond fund can change independently of the SEC yield. If a bond fund bought $10,000 in bonds which pay $200 annually in coupons, but the price of those bonds has fallen to $9000, the bonds are now paying a dividend of 2.22% of their value; meanwhile, the SEC yield might have risen from 2% to 3%. If the fund sells those bonds (for a capital loss) and buys new bonds with a 3% yield, the dividend payment will rise from $200 to $270, while the SEC yield stays at 3%.

In addition, you should be looking at the change in yield as a percentage of the fund value, not a percentage of the yield. If the yield on a bond fund rises from 2% to 3%, that is a 50% relative increase in the yield, but only a 1% increase in the return as a result of the yield. If the fund lost 6% when the yield increased, your one-year return will be -3%, and if rates don't change in the future, your six-year return will be the same 2% as if rates hadn't changed.
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Re: Bond prices drop but their yields go up??

Post by Scrapr » Sun Nov 04, 2018 1:07 pm

patrick wrote:
Sun Nov 04, 2018 12:14 pm
Scrapr wrote:
Sun Nov 04, 2018 11:51 am
Let me ask this. I understand individual bonds go up & down in value with interest rates. Now bond funds do not have a fixed end date. The bond fund owns lots of bonds

I look at my Vanguard Total Bond Fund and see it has gone down approx 10% in value. Balanced by the increase in dividends. Is the 10% decrease reflecting the increasing dividends? Vanguard is down this weekend for repairs.....errr maintenance or I would try to calculate it. Off the top of my head I think the dividend has increased by approx 10%.

So shouldn't the return calculated by VG YTD be closer to zero? Instead of neg 10%?
The price of Vanguard Total Bond is down by about 4.9% YTD. The total return, including dividends, is down by about 2.7%. The increased yield will eventually make up for the price decline but it doesn't happen immediately (and is complicated by future interest rate changes).
ohh, I peeked a couple days ago. Part of my coping mechanism when markets go down is I don't look. (LOL) I had thought I saw neg 10%. And I'm like whaaa???? I was prepared for about 5%+/-. The bigger drop made me think the increased dividend would be difficult to overcome the drop in value. But of course it will balance out in the long run. Maths is hard...(for me)

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Re: Bond prices drop but their yields go up??

Post by arcticpineapplecorp. » Sun Nov 04, 2018 9:25 pm

to confirm what patrick wrote, the total bond market index fund performance YTD is -2.69% :

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edvest
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Re: Bond prices drop but their yields go up??

Post by edvest » Mon Nov 05, 2018 5:59 am

I thought this was my post, not scrapr's?

I'm still not sure if anyone answered my 524% questions.
While maybe not normal for Vanguard, do bond funds really turn over this much, and if so, how is that even possible?

tu

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Re: Bond prices drop but their yields go up??

Post by Valuethinker » Mon Nov 05, 2018 6:43 am

edvest wrote:
Mon Nov 05, 2018 5:59 am
I thought this was my post, not scrapr's?

I'm still not sure if anyone answered my 524% questions.
While maybe not normal for Vanguard, do bond funds really turn over this much, and if so, how is that even possible?

tu
I have answered you in some detail in the post immediately after yours.

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Re: Bond prices drop but their yields go up??

Post by BeBH65 » Tue Nov 06, 2018 6:11 pm

edvest wrote:
Mon Nov 05, 2018 5:59 am
I'm still not sure if anyone answered my 524% questions.
While maybe not normal for Vanguard, do bond funds really turn over this much, and if so, how is that even possible?

tu
In addition to the answer Valuethinker gave you on your immediate question,
you might also find info that you find interesting info in this thread Why does TBM have such high turnover?

I found this a good information (might not explain everything - clik on the littel arroz to read the full post)
alex_686 wrote:
Fri Aug 10, 2018 1:58 pm
What is an index provider supposed to do when a popular bond that is included in the index does not trade for a week? Guess at its price?
Nope. They drop the bond and replace it with another similar bond. Happens all of the time.
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Re: Bond prices drop but their yields go up??

Post by alex_686 » Wed Nov 07, 2018 11:32 am

Valuethinker wrote:
Sun Nov 04, 2018 10:37 am
(Confusingly, by a strict definition, TBM is an "active" fund. Rather than slavishly following a specific index, Vanguard feels it is actually better to construct a portfolio with *around* the characteristics of the index, but without having to hold many bonds in the index which are of low liquidity, or to be heavily weighted towards part of the bond market (like US govt mortgage backed securities) which they find to be unattractive (on objective, quantitative grounds***). For practical purposes, you can treat it like an index fund -- it has appealingly low costs**).
I would like to see a cite for that. When I was working in the biz, the SEC would have squashed this hard as deceptive marketing. If you have "index" in your name you had better be trying replicate the returns of that index and not making subjective or active asset selections.

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