ORANGE COUNTY IN BANKRUPTCY : The Mechanics of a Bond

Why is it that bond owners lose money as market interest rates rise? Think of a seesaw, with a bond’s price on one end and its yield on the other. The two ends always move in opposite directions.

*

Take the example of a U.S. Treasury 30-year bond issued in 1993. An investor who bought it new paid $1,000 for a security that will pay 6.25% interest, or $62.50, annually for the next 30 years.

*

That may have seemed like a decent enough return at the time. But since then, market interest rates have zoomed. Today, investors are demanding a yield of 8.1% on new 30-year T-bonds.

*

The owner of the older T-bond still are earning 6.25%, and if he hold the bond to maturity he’ll get his full $1,000 back, as well.

*

But if he tries to sell the bond now, buyers naturally will demand that the yield match the market.

*

To accomplish that, the bond’s price is marked down. Instead of $1,000, the market price of the bond today is about $793, a 21% decline from what the original investors paid.

*

Divide annual interest earnings of $62.50 by $793 and you get a ‘current” yield of about 7.9% for a new buyer. And by factoring in the added return expected by reinvesting the bond’s annual interest earnings, the true yield-called “yield to maturity’-works out to about 8.1%, thereby matching the market.

*

What happens if market yields begin to decline again? As the seesaw analogy implies, the bond’s price will rise accordingly.

Price: $1,000

Yield: 6.25%

*

Price: $793

Yield: 8.1%