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Bond fund return, bond price and bond yield explained

Why does bond return drop in a rising bond market?

Mandatory Provident Fund (MPF) members often ask us why bond fund return drops in a rising bond market. Many of them mistake rising bond yield as a sign of a rising bond price, but the opposite is actually true.

What are bonds?

Put simply, a bond is an investment tool that works like an IOU (I owe you). When a government or corporation wants to raise money, they may issue a bond that specifies the principal, coupon interest, and repayment due date. Investing in bonds offers investors stable returns and a way to diversify their portfolios. 

This IOU can be traded in the second-hand market at any time before its maturity date. So, the actual yield does not always equal the sum of the interest and principal agreed upon at the time of the loan.

Understanding the relationship between bond market and bond fund performance

The condition of the bond market is usually represented in terms of bond yield, which is the expected return rate of holding a bond until it matures. This value depends on the bond price in the secondary market.

The following formula helps debunk the myth that bond fund return increases in a rising market.

Bond yield = Coupon interest (constant) / Current market price

The simplified formula above shows that bond yield and bond price go in an opposite direction. When bond yield goes up, the bond price drops, and this is associated with a fall in bond fund performance.

Bond yield rises = Bond price drops = Bond fund returns goes down

Bond yield drops = Bond price rises = Bond fund returns goes up

For example, Member A bought a bond from the issuer on the issue date at a face value of HKD1,000 for a year with a coupon rate of 5%. The coupon rate is the promised interest rate from the issuer when a bond matures, and this doesn't change.

After one year, Member A will receive HKD1,050 (the sum of a principal of HKD1,000 and an interest of HKD50). If Member A holds the bond from the issue date to the maturity date, the bond yield equals coupon rate, for example, 5%.

However, bonds can be traded in the secondary market before the maturity date. A bond's price in the secondary market (current market price) is affected by factors such as credit rating, demand and supply, which fluctuate before the bond matures.

Member B bought the same bond from the secondary market at HKD1,100. Its coupon rate remains at 5%, and the bond yield is only 4.55% (HKD50 / HKD1,100).

So, when the bond price goes up, the bond yield drops:

Relationship between bond price and bond yield

  Purchase price of bond Tenor Coupon rate Bond yield
Member A $1,000 1 year 5% 5% ($50/$1,000)
Member B $1,100 1 year 5% 4.55% ($50/$1,100)

Relationship between bond price and bond yield

  Member A Member A
Purchase price of bond $1,000 $1,000
Tenor 1 year 1 year
Coupon rate 5% 5%
Bond yield 5% ($50/$1,000) 5% ($50/$1,000)
  Member B Member B
Purchase price of bond $1,100 $1,100
Tenor 1 year 1 year
Coupon rate 5% 5%
Bond yield 4.55% ($50/$1,100) 4.55% ($50/$1,100)

What does bond yield mean to investors?

Bond yield helps investors determine the actual returns of a bond so they can compare it with that of other investment tools, such as saving.

Coupon rate is the promised return by the issuer, so it remains unchanged until the maturity date.

With a constant coupon rate, when bond yield rises, the bond price goes down. Net asset value as well as returns of bond funds that invest in investment grade bonds will also go down.

So, next time you read that the bond market is going up (generally speaking, when bond yield is rising), you'll know it doesn't necessarily mean a positive bond fund return.

Formulating MPF investment strategies

MPF is a long-term retirement investment tool. You're not encouraged to time the market. Instead, adopt a dollar-cost averaging strategy and make contributions on a regular basis. You should also diversify your fund portfolio to reduce the investment risks. During market downturns, the relatively stable low-risk funds may offset the losses brought by high-risk funds.

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1. Investment involves risks. Past performance is not indicative of future performance. The value of financial instruments, in particular stocks and shares, and any income from such financial instruments, may go down as well as up. For further details including the product features and risks involved, please refer to the MPF Scheme Brochure. 

2. The content shared in this article should not be viewed as investment recommendation and advice. You should seek professional analysis and advice before making any decisions related to the information shared in this article.