It's a simple rule to memorize, but why does it happen? Understanding the "why" is the key to synthesizing the knowledge and answering the tricky ways FINRA will ask about it.
What is the Bond See-Saw?
The "see-saw" is just a simple analogy. Picture a see-saw in a playground:
- When the Interest Rates side goes UP, the Bond Prices side must go DOWN.
- When the Interest Rates side goes DOWN, the Bond Prices side must go UP.
This is called an inverse relationship. They always move in opposite directions. This is so ingrained in me from studying that to this day my hand tilts like the see-saw to remind me of the relationship.
But Why Does This Happen? (The Simple Answer)
The entire see-saw effect is driven by one simple fact: new bonds being issued are more (or less) attractive than your old bond.
A bond's nominal or coupon rate is locked in when it's first issued. (imagining the see-saw, remember "nominal never moves," its the fulcrum) If you buy a 10-year, $1,000 bond today that pays a 5% coupon, it will pay you $50 every year for 10 years. That is set in stone.
Now, let's see what happens a year later.
Scenario 1: Interest Rates GO UP to 7%
- The Market: New $1,000 bonds being issued today now pay a 7% coupon (or $70 per year).
- Your Bond: You're still holding your "old" bond that only pays 5% (or $50 per year).
- The Problem: If you try to sell your 5% bond, why would anyone buy it from you for $1,000 when they can just buy a *new* bond for $1,000 and get 7%?
- The Solution: You have to sell your bond at a discount (less than $1,000) to make it attractive. Therefore, the *price* of your old bond has to go down.
See-saw: Interest rates went UP (to 7%), so the price of your existing bond went DOWN.
Scenario 2: Interest Rates GO DOWN to 3%
- The Market: New $1,000 bonds being issued today only pay a 3% coupon (or $30 per year).
- Your Bond: You're still holding your "old" bond that pays a glorious 5% (or $50 per year).
- The Opportunity: Your bond is now incredibly valuable! Everyone wants your 5% bond, not the new 3% bonds.
- The Solution: You can sell your bond for *more* than its face value. This is called selling at a premium. Therefore, the *price* of your old bond has to go up.
See-saw: Interest rates went DOWN (to 3%), so the price of your existing bond went UP.
The Key Takeaway
The "price" of a bond in the secondary market is a balancing act to make its old, fixed coupon competitive with the new interest rates in the current market. That's all the see-saw is!
This is one of the most heavily tested concepts on the SIE and Series 7. The best way to master it is to practice questions.
The Different Yields: A Quick Look
When discussing bonds, it’s not enough to just know the coupon rate. As the market price of a bond changes, so does its effective yield. Understanding these different yields is critical for the SIE and Series 7 exams.
Nominal Yield (Coupon Rate):
This is the simplest. It's the fixed interest rate the bond issuer promised to pay when the bond was first issued. It never changes.
Example: A $1,000 bond with a 5% coupon pays $50 annually. Its nominal yield is 5%.
Current Yield:
This measures the annual income (coupon payment) relative to the bond's current market price. It changes as the bond's price fluctuates in the secondary market.
Formula: Annual Interest / Current Market Price
Example: Your 5% coupon bond ($50 annual interest) is now trading at $800. Its current yield is $50 / $800 = 6.25%.
Yield to Maturity (YTM):
This is the most comprehensive yield. It represents the total return an investor expects to receive if they hold the bond until it matures. It considers the coupon payments, the current market price, and any capital gain or loss if bought at a discount or premium.
YTM is generally considered the bond's overall return if held to maturity.
Yield to Call (YTC):
This is similar to YTM but applies to callable bonds (bonds that the issuer can "call back" before maturity). YTC calculates the return if the bond is called at its first possible call date, which is often done when interest rates fall.
How Yields Relate to the See-Saw
- When a bond is at par, everything is equal:
- Nominal = Current = YTM = YTC
- When a bond is above par, the yields weigh the see-saw down so:
- Nominal > Current > YTM > YTC
- When a bond is below par, the bond price is weighing the see-saw down so:
- Nominal < Current < YTM < YTC
How to remember which yield type comes before which on the see-saw (because FINRA will absolutely test you on this)? I use the Mnemonic Nancy Currently Makes Calls.