Yields Up! Prices Down!
You probably cannot scan half way through your national business newspaper without hearing about the Federal Reserve or the Bank of Canada and some type of speculation about when interest rates are going to rise.
This speculation is often followed by the boilerplate "when yields go up, bond prices go down", without any explanation about why this is so. Apparently, editors expect that you either know why (in which case I find the statement redundant), or that you will just accept that it's true and try to remember it as a rule. I have often wondered if this irritates some readers who would like to know why, but would prefer a needle in their eye rather than sit through a bond pricing lecture.
Well, here is why, in a nutshell.
Before I start, I have to say that many retail investors consider bonds, especially government bonds, to be a risk free investment. This is true, to a point. A Government of Canada Bond or US Treasury Bill is probably as safe as you'll get, in that you will get your principal back. However, all bonds are subject to interest rate risk.
Suppose you walk into your bank today and buy $10,000 in 1-year Government of Canada Bonds yielding 1.75%. You buy 100 blocks of $100 bonds, because every bond is priced at $100. This is called their "par" value. In one year you expect to get $10,175 back. You now go home proud to have made an investment rather than putting a down payment on a Beemer.
Now, suppose that the very next day, the Bank of Canada decides to raise the overnight rate by 0.25% (or 25 basis points, to get fancy). To your dismay, you go to your bank website and see that the exact same bond you bought yesterday yields 2% instead of 1.75%. When you cash in that bond at the end of the year, you'll be $25 short.
You think at this point that you should sell your block of bonds and go buy those better bonds and get your extra $25. The problem is that nobody will want to pay you $100 for each of your bonds now, because they can get more, just like you, by going to the bank and buying new ones.
In fact, your bonds just went down in price to $99.755 (yes, half a penny). At this price, other investors would be satisfied that your bond will yield 2% at the end of the year, when they collect the $10,175 that your bonds will pay out.
And that is why, when yields go up, bond prices go down.