As you look at all the options available to invest in bonds, you will find a very large number of investment opportunities, many with significantly different yields. As an investor, you want to earn a higher yield. Understanding the factors involved with different yields will let you select bond investments that meet your personal risk tolerance.
Yield Versus Risk
Prices and yields in the bond market always reflect the risk involved with a specific bond investment. To earn a higher yield, an investor must accept some form or type of additional risk. The current market yield of bonds reflects the different risk factors associated with that bond.
Once you buy a bond, your yield is locked in, and the changes in market interest rates will be reflected in the market value of the bond if you decide to sell. Bond prices and interest rates move inversely. If rates increase, bond prices decline. And if rates fall, bond prices will go up.
Issuer's Credit Quality
The yield a bond pays is dependent on the credit quality of the issuer. The U.S. government is considered to be the safest issuer of bonds, so U.S. Treasury bonds have the lowest yields when other factors are the same. Bond issuers have credit ratings indicating the ability to make timely interest and principal payments.
Ratings are letter grades, with AAA as the top rating, then moving down through AA, A, BBB and continuing the pattern to a single C or D (depending on the rating agency). Credit ratings of BBB or higher meet the definition of investment grade bonds. Bonds with lower ratings are considered to be noninvestment grade and are referred to as high-yield or junk bonds. The lower the credit rating, the higher the yield a bond will pay.
Time to Maturity
During periods of normal economic conditions, the yields on a longer term will be higher than for a shorter term bond. Investors expect to be paid a higher rate in exchange for locking money up for a longer period of time.
The relationship between term and rate is called the yield curve. A normal yield curve slopes upward to show longer-term rates higher as the term increases. In periods of economic disruption, the yield curve can flatten or even go inverted with short rates higher than long-term rates.
Future Inflation Expectations
The rates on low-risk longer-term bonds reflect the bond market outlook on inflation. If bond investors think inflation will increase, bond yields will increase and bond prices will decline. Bond investors expect to earn the rate of inflation plus some extra interest over the term of any bond. Current bond yields move up and down as the expectations about future inflation change.
The yields and prices of long-term bonds are set by market supply and demand. Yields at the short end of the yield curve – terms shorter than two years – are more influenced by policies of the government and the Federal Reserve.