In this video we go a little deeper into the relationship between bonds, their prices, their yields and their key drivers.
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We just have a quick question here from Sakeem, asking for more information on bonds, bond prices, bond yields and how all of this comes back to the risks done on a daily basis.
When we normally talk about bonds, we are referring to government bonds. And the reason of course, why governments would issue bonds in the first place is because they want to raise capital.
So we have the US government, for example, they need to raise money, so they issue new government bonds in order to borrow money from willing lenders, which are those who buy the bonds, but of course, they need to pay you something for lending them the money, right. So, they will give you an interest payment, some interest on that.
Now, when you buy a bond, lets say you buy a government bond for $1,000 at par value, you also get what is called a coupon and that is normally the fixed interest payment from the government as an interest for borrowing them the money. So imagine that you buy a bond at an interest rate of 3% That would mean that you get paid $30 every year in interest for the thousand dollars that you've lend to the government.
Now you can calculate the yield for that bond by simply taking the coupon payment, which is $30. So let's take $30, and you divide that by the price that you paid for the bond, and that'll give you your 3% yield. So from this, you can see that there is an inverse relationship between bonds and their yield.
Now, this is important because, bonds can be traded in both the primary and the secondary market.
So, once a bond has been bought and issued for the first time, so, let's say you're that first buyer of that bond for the thousand dollars, after that, that bond can be traded like any other asset in the secondary market, and bonds will be bought and sold for many different reasons based on the quality and base on the economy.
The first one is quality. So, what is the quality of the bond? If it's a triple A rated government bond like a US bond, for example, that is considered to be a very safe investment because the US has a very slim chance of defaulting on their debt, right?
Compare that to a country like Venezuela, for example. If you wanna buy a bond from them, they will need to offer you a much higher yield, because you basically need to, you're taking the risk on lending them that money and you might not get that money back. So they need to offer you a more attractive coupon rate a more attractive yield for you to buy that bond. Another thing to keep in mind apart from the creditworthiness is the actual economic climate for a government bond, right.
So what are the expectations of rising and falling interest rates. So a triple A rated government bond from the US is considered as one of the safest investments that money can buy, because the default risk is very low. So when bond investors think that the economy is slowing, they will start accumulating bonds from a safe haven point of view. Now the increase in demand for those bond purchases pushes up the bond price. And thus obviously pushes down the bond yields.
So the expectation of a slowing economy means that the market will start to eventually expect lower interest rates from the Federal Reserve, right? Which is another reason why bond holders essentially the bondholders that wants to buy and hold like a pension fund, if they know that or they think the economy is going to slow, they would like to buy bonds while the interest rate is still attractive.
Okay, so if you would want anybody to buy that bond, you can't, you can't get the same money that you paid for it right, you would need to offer them that lower price. So you would need to offer them that, if it's 3% and 4%, you would need to offer them 750 for that bond, just in order to get the same yield that they can get for a new bond in the market. So that is how the bond price obviously in the secondary market, how things like interest rate expectations changes, why they want to sell and buy bonds, as the interest rate obviously affects what they can get in terms of yield.
So, Sakeem, I hope that helps with your question giving you a little bit more context on exactly how we relate back to bonds and bond prices and bond yields and how of course that relates back to the overall risk done.
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