The Basics of Bonds

A bond is an IOU, a promise to pay an amount of money at some point in the future. Suppose that a pizza restaurant wants to borrow money to buy a new oven to bake pizza. For $950, it might sell a bond that promises to pay $1,000 in a year's time. The yield (y) on this one-year bond would be the interest rate that makes the bond's discounted payoff equal to its price:

payoff/(1 + y) = price or y = payoff/price - 1.

In the case of a bond that costs $950 and pays off $1,000 a year later, the yield is 5.3 percent. The buyer of the bond lends the restaurant $950 until the bond is paid off.

Bond prices and bond yields are inversely related. When the price of a bond rises, a greater investment is needed to get the same payoff; so, the yield on the bond falls. In our hypothetical example, if demand is high, the restaurant might be able to sell these same bonds for $970 and still return just $1,000 at the end of the year. The yield then would be about 3.1 percent. Conversely, when prices on bonds fall, yields rise.


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