Bond Prices and Yields - The Relationship That Confuses Everyone

She read it three times. Yields surging and prices falling simultaneously. To her, those sounded like the same thing. If something is getting more expensive it should be worth more, not less.

She asked her more experienced colleague. He drew a quick example on a piece of paper. She said nothing for a moment. Then she said: that is actually obvious when you see it that way.

It is. But only once someone shows you.

The following week, interest rates in the economy rise. The government issues new bonds paying a coupon of 6%, $60 per year for every $1,000. These new bonds are better. They pay more.

You decide to sell your bond. You are asking $1,000 for a bond that pays $40 per year when investors can buy a new bond for $1,000 that pays $60 per year. Nobody will pay $1,000. Why would they?

So you lower your price. You keep lowering it until your $40 annual payment represents a competitive return on the lower price. Eventually you price it at around $667. Now $40 divided by $667 is approximately 6%, the same yield as the new bonds. At this price buyers appear.

Your bond''s price fell from $1,000 to $667. Its yield rose from 4% to approximately 6%. Price fell. Yield rose. Simultaneously. Because they are mathematically linked.

Now reverse it. Interest rates fall. New bonds pay only 2%. Your old bond paying $40 per year is suddenly very attractive. Buyers compete for it. The price rises to $2,000. At $2,000 your $40 payment represents a 2% yield. Price rose. Yield fell. Always, without exception, in every bond market in the world.

The yield to maturity is the total annualised return an investor would receive if they bought the bond at today''s market price and held it all the way to maturity, collecting every coupon payment along the way. This is what traders and analysts quote when they say the 10-year yield is 4.5%.

A bond price of $956 means very little in isolation. A yield of 4.8% immediately tells you what the market is demanding as a return for lending to this particular borrower for this particular period. It is comparable to any other yield, any other instrument, any other market in the world. This is why yield is the language of bond markets rather than price.

The reason is time. Almost all of a 30-year bond''s cash flows are far in the future. When interest rates rise and those distant cash flows are discounted at a higher rate, their present value falls dramatically. The price of the bond falls sharply.

Almost all of a 2-year bond''s cash flows arrive very soon. A rise in interest rates barely affects the present value of cash flows arriving in the next two years. The price barely moves.

The practical implication is direct. When you expect rates to fall, long bonds are where the most dramatic price appreciation will come from. When you expect rates to rise, short positions in long bonds will move the most. A 1% rise in interest rates might cause a 30-year bond to fall 20% in price while a 2-year bond falls just 2%. Same direction. Completely different magnitude.

When real yields are negative, when inflation is running higher than the nominal interest rate, holding cash costs you purchasing power. This is the environment where gold becomes extremely attractive as a store of value. It pays nothing but it holds its purchasing power.

When real yields are positive and rising, when you can earn a genuine positive return above inflation from safe government bonds, gold faces headwinds. Why hold something that pays nothing when cash pays a positive real return?

The surge in gold prices in 2020 to 2022 happened when real yields went deeply negative as central banks held rates near zero while inflation surged. The headwinds gold faced in late 2022 and 2023 came directly from the Fed hiking rates faster than inflation, pushing real yields positive. One relationship. Enormous explanatory power.