Understanding bonds and bond prices is an essential aspect of making this type of investment. There are a number of elements to take into consideration when choosing bonds to purchase, but one that stands out is looking at what they are correlated to and how this affects your investment.
Making the Correlation
So if you’ve ever taken a look at bond prices, you probably have noticed that in a column nearby is mention of a yield. The yield represents the relationship between the bond’s dollar price and its cash flows (the interest payments and return on your principal amount that you receive throughout and at the end of your term, respectively). So basically, you’re looking at how the dollar is moving in relation to the type of returns you’ll gain for the term period you’ve agreed to.
When you look at bond prices on a chart, you’ll notice that yield prices are always moving in the opposite direction. For instance, if you notice that 2-year bonds hold a price of 98-29 ¾ and 3-year bonds hold a price of 97-28 ¼ then the yields may show 4.93 and 4.95, respectively. In layman’s terms, this means that agreeing to a longer-term bond results in a cheaper price and higher return – and vice versa. The connection between a bond and yield is inseparable, which is why many take time to recognize the correlation between them.
There is a lot more to understand about bonds before you should dive in and take this type of investment by the reigns. But understanding bond prices and their correlation to yields helps to demystify this profitable investment option.