I Simplified Bonds and Yields For You
Updated: Sep 12, 2022
As interest rates rise you may want to learn more about bonds.
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U.S. Treasury Securities
Treasuries are securities issued by the federal government and are considered the safest investment. In addition, the U.S. government fully backs them. Therefore, no matter what happens to the economy, the U.S. plans to protect its bondholders. The four types of Treasuries are Treasury Bills, Treasury Notes, Treasury Inflation-Protected Securities, and Treasury Bonds.
Treasury bills have the shortest maturities, ranging from a couple of days to a year.
Treasury notes have maturities ranging from 2–10 years and pay interest every six months.
Treasury bonds have maturities ranging from 20–30 years and pay interest every six months.
Treasury Inflation-Protected Securities (TIPS)
TIPS pay interest every six months, and its principal is adjusted with changes in the consumer price index (CPI). Maturities range from 5 to 30 years.
Bonds and Yields Explained
You lock in a holding period and an interest rate when you buy a bond. As a result, your return at maturity is the same regardless of what happens between the maturity date and when you purchase the bond. For example, if you buy a bond that pays 2% interest for 5 years, this is what you get regardless of how the bond is priced after you purchase it.
The yield or discount rate of a bond matches the cash flow to its current price. As inflation expectations rise, the yields of bonds increase, thus decreasing the bond price. Bond yields and pricing move inversely to each other. Therefore, as interest rates rise to fight inflation, bond prices will fall.
The yield curve is a line graph of the rates of bonds with different maturities. Under normal circumstances, the longer maturity bonds have higher rates than the shorter maturities. The longer maturities pay more because the investor’s money is at more risk due to the time they must commit the funds.
The yield curve inverts when shorter maturity bond rates are higher than longer-term maturities. Many consider this a sign of a recession, but it is still hard to predict when a recession will occur. Moreover, recessions have occurred more than a year after the yield curve inverts, so it is not always a sign to sell your stocks.