This statement represents the easiest way to remember the relationship between bond prices and yield to maturity: "When bond prices go up, bond yields go down and vice versa." OK, that’s all well and good, but why does it happen that way? To answer that, we need to understand how bond prices and interest rates work.
What Is a Bond?
In its most basic form, a bond acts as a debt instrument. It’s kind of like an IOU or a pledge to repay. When a company issues bonds (or a city, state, municipality etc.) that company basically says, if you buy our bonds (loan us money) we promise to pay you interest (coupon rate) over the life of the bond and when the full payment is due (maturity date) we will pay you back the original investment. When you purchase a bond, you buy it at one of three price points: at par, at a premium or at a discount. A bond bought at par means the coupon rate equals the current interest rate. A bond bought at a premium means the coupon rate is higher than the existing interest rate and a discounted bond means the coupon rate is lower than the existing interest rate. Bonds pay coupon payments semiannually. For example, a two-year $1,000 bond with a 5 percent coupon would pay you two payments of $25 the first year, one $25 payment the first part of the second year and one final payment of $1,025 the second half of the second year.
Think of par value as par in golf. You made the hole in the required amount of strokes, not too many and not too few. The price you pay for a bond centers on its par value of 100 because when the bond matures you receive 100 percent of its value.
Yield to Maturity
Yield to maturity, sometimes called YTM, really refers to the anticipated rate of return of a bond if you hold it until it matures and if you reinvest all of your coupon payments at a fixed interest rate. This represents the return you receive from your entire investment, not just your initial bond investment.
Putting It Together
If you buy a $1,000 bond at par value and a coupon rate of 5 percent you will receive interest payments of 5 percent each year until the bond matures. But what if the current interest rate goes up to 6 percent? Well, you would still receive payments of 5 percent interest on your bond because you have a locked-in rate. But what if want to sell your bond? To make your 5 percent interest-bearing bond attractive to buyers that can receive 6 percent interest on new bonds, you would have to sell your bond at a discounted price. This discounted price has to make up for the fact that the buyer receives a lower rate of return (yield to maturity) over the life of your bond than from bonds currently in the market. So, as the interest rate rose, the price of your bond dropped to compensate for the lower return rate (yield to maturity) a buyer would receive from your bond vs. a newer bond at a higher rate. The exact opposite happens if current interest rates drop and your bond has a higher interest rate. The price of your bond would increase to offset the loss of return a buyer would receive from new bonds at the lower interest rate.