You can find quotes on bond yields and prices in The Wall Street Journal or on FIRNA’s Market Data Center. A bond is basically an I.O.U. or promissory note. A government or a company issues bonds in order to borrow money directly from investors. This is cheaper than borrowing from a bank because the bank adds overhead and profit to its loans. A bond is a promise to pay interest to the investor every year and then to pay back the investor at the end of a specified time period. A bond’s time period is also known as its length, term, or maturity. For example, the U.S. Government issues Treasury Bonds in order to finance the ongoing annual deficit. Currently, a newly issued 10-year Treasury Bond would likely have the following characteristics:
- Face Value Amount or Par: $1,000
- Coupon or Yield: 0.7%
- Maturity or Term: 10 years
This means that the owner of the bond will receive interest payments every year of $7.00 until maturity and will receive the $1,000 back at the end of the ten years. The interest payment is calculated as $1,000 X 0.007 = $7.00.
The current 0.7% yield of the 10-year Treasury Bond is extremely low and was manipulated by the Federal Reserve Bank in the last two recessions. The Fed purchased trillions of dollars’ worth of Treasury Bonds and, due to supply and demand, brought down long-term interest rates. Even though the investor may have purchased the Treasury Bond when it was first issued, they do not have to hold the bond for the next ten years. They can sell the bond in the secondary market. On average last year, $600 billions’ worth of Treasury Bonds were bought and sold every day in secondary bond markets. The U.S. government is constantly issuing new Treasury Bonds to fnance the fscal defcit and to refnance existing Treasury Bonds as they mature and must be repaid. The total amount of outstanding U.S. Treasury Bonds is the National Debt and is currently about $18 trillion. According to the Brookings Institute, as of April 2020 of the $18 trillion outstanding U.S. Treasury Bonds:
- $3.5 trillion were held by U.S. households, companies, and governments
- $3 trillion by asset managers
- $2.5 trillion by the Federal Reserve
- $2 trillion by banks and insurance companies
- Nearly $7 trillion (40%) were held overseas, mostly by foreign central banks
When bonds are sold in the secondary market, the price at which the investor buys them may not be the Face Value of Par (typically $1,000). That is because the price adjusts to reflect the current interest rates in the marketplace. For example, in the table below, you see that although the coupon remains constant at the same annual payment as when the bond was first issued, the marketplace bids up or down the price to achieve the desired yield:
Table 13.1. Bond Prices and Yields Fixed Dollar Amount Example
You may have read in The Wall Street Journal that bond prices and bond yields move in opposite directions. This is because the coupon is fixed at the issuance date of the bond and when the price goes up, the yield goes down and vice versa.
The above example used a fixed dollar amount for the interest paid annually on the bond. However, the coupon is an actual interest rate that will be paid annually, and the yield fluctuates the same way as in the table above:
Table 13.2. Bond Prices and Yields Coupon Example
The U.S. Treasury issues Treasury Bonds of many different maturities for their different borrowing needs (e.g. tax anticipation, long term defcits, etc.). The daily yields of these treasuries are depicted in a yield curve. The yield curve is published every day in The Wall Street Journal.
Figure 13.5. U.S. Treasury Bonds Yield Curve. Source: U.S. Department of the Treasury data.
The graph above shows that the historical yields of 10-year U.S. Treasury Bonds have been significantly higher in the past.
Because inflation is a component of nominal interest rates, we can use the 10-year Treasury to see how the market anticipates the rate of inflation in the future. In 1997, The Treasury Department began to issue what are called Treasuries with Infation Protection (TIP) in response to investor demand. In addition to the coupon yield, the Treasury protects the TIP owners by increasing the principle of the bond after the end of the year, based on inflation. The Consumer Price Index is used as a gauge for inflation, thus guaranteeing that the purchasing power of the bond-holder’s original investment will not decrease.
Nominal interest rates on regular 10-year Treasuries have both a time-value of money component (the real interest rate) and an inflation component. 10-year TIPs contain only the real interest rate. Therefore, using the difference between the yield on the regular 10-year Treasury Bond and the 10-year TIP, we can accurately gauge expected inflation. Below, I have added a graph showing the two different yields. For current quotes, visit The U.S. Department of the Treasury.
Figure 13.6. Board of Governors of the Federal Reserve System (US), 10-Year Treasury Constant Maturity Rate [DGS10] and 10-Year Treasury Infation-Indexed Security, Constant Maturity [DFII10], retrieved from FRED, Federal Reserve Bank of St. Louis; October 1, 2021.
There are other types of bonds besides U.S. Treasuries. Bonds are classified according to the type of issuer:
- Treasury Bonds
- Corporate Bonds
- Municipal Bonds
- Federal Agency Bonds
- State Agency Bonds