Bond Pricing, Yield & Duration

Introduction

Bond prices move opposite to interest rates, and yield tells you the true return. Duration measures how sensitive a bond is to rate changes. This lesson demystifies these three ideas.

Bond Prices and Interest Rates

There is an inverse relationship: when market interest rates rise, existing bond prices fall, and vice versa.

Interest rates UP   ->  existing bond prices DOWN
Interest rates DOWN ->  existing bond prices UP

Why? A new bond issued at a higher rate pays more, so older, lower-coupon bonds must fall in price to stay competitive.

Yield

There are a few yields:

• Current yield — annual coupon ÷ current price
• Yield to maturity (YTM) — total return if held to maturity, including coupons and the price change to par

Premium and Discount

• A bond trading above par sells at a premium (when its coupon beats current rates)
• A bond trading below par sells at a discount (when its coupon lags current rates)

Duration

Duration estimates how much a bond's price changes for a 1% move in interest rates.

High duration  ->  price swings more with rates
Low duration   ->  price swings less

Longer-maturity bonds generally have higher duration.

Real-World Example

You hold a 30-year bond yielding 3%. Market rates rise to 4%. Your bond's price falls because new bonds pay more. The longer the maturity (duration), the larger the price drop.

Summary

• Bond prices fall when rates rise (and rise when rates fall)
• Yield to maturity captures coupons plus price change to par
• Above par = premium; below par = discount
• Duration measures sensitivity to interest-rate changes
• Longer duration = more price risk

Next Lesson

Government bonds vs corporate bonds.