
Understanding the price fluctuation of bonds is probably the most confusing part of this lesson. In fact, many new investors are surprised to learn that a bond's price changes on a daily basis, just like that of any other publiclytraded security. Up to this point, we've talked about bonds as if every investor holds them to maturity. It's true that if you do this you're guaranteed to get your principal back; however, a bond does not have to be held to maturity. At any time, a bond can be sold in the open market, where the price can fluctuate  sometimes dramatically. We'll get to how price changes in a bit. First, we need to introduce the concept of yield.
Measuring Return With Yield
Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.
Let's demonstrate this with an example. If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). Pretty simple stuff. But if the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).
Yield To Maturity
Of course, these matters are always more complicated in real life. When bond investors refer to yield, they are usually referring to yield to maturity (YTM). YTM is a more advanced yield calculation that shows the total return you will receive if you hold the bond to maturity. It equals all the interest payments you will receive (and assumes that you will reinvest the interest payment at the same rate as the current yield on the bond) plus any gain (if you purchased at a discount) or loss (if you purchased at a premium).
Knowing how to calculate YTM isn't important right now. In fact, the calculation is rather sophisticated and beyond the scope of this tutorial. The key point here is that YTM is more accurate and enables you to compare bonds with different maturities and coupons.
Putting It All Together: The Link Between Price And Yield
The relationship of yield to price can be summarized as follows: when price goes up, yield goes down and vice versa. Technically, you'd say the bond's price and its yield are inversely related.
Here's a commonly asked question: How can high yields and high prices both be good when they can't happen at the same time? The answer depends on your point of view. If you are a bond buyer, you want high yields. A buyer wants to pay $800 for the $1,000 bond, which gives the bond a high yield of 12.5%. On the other hand, if you already own a bond, you've locked in your interest rate, so you hope the price of the bond goes up. This way you can cash out by selling your bond in the future.
Price In The Market
So far we've discussed the factors of face value, coupon, maturity, issuers and yield. All of these characteristics of a bond play a role in its price. However, the factor that influences a bond more than any other is the level of prevailing interest rates in the economy. When interest rates rise, the prices of bonds in the market fall, thereby raising the yield of the older bonds and bringing them into line with newer bonds being issued with higher coupons. When interest rates fall, the prices of bonds in the market rise, thereby lowering the yield of the older bonds and bringing them into line with newer bonds being issued with lower coupons.
If you are looking for more information about lower risk investments such as bonds, Investopedia's Ask an Advisor tackles the topic by answering one of our user questions.
Bond Basics: Different Types Of Bonds
Markets
Understanding the Different Types of Bond Yields
Any investor, private or institutional, should be aware of the diverse types and calculations of bond yields before an actual investment. 
Markets
Bond Yields: Current Yield And YTM
A bond's current yield, also called "bond yield," is the interest it pays annually divided by the bond's price. A stock's current yield, also called "dividend yield," is the sum of its annual ... 
Managing Wealth
Understanding Bond Prices and Yields
Understanding this relationship can help an investor in any market. 
Managing Wealth
5 Basic Things To Know About Bonds
Learn these basic terms to breakdown this seemingly complex investment area. 
Managing Wealth
How To Evaluate Bond Performance
Learn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk. 
Markets
Simple Math for FixedCoupon Corporate Bonds
A guide to help to understand the simple math behind fixedcoupon corporate bonds. 
Markets
Comparing Yield To Maturity And The Coupon Rate
Investors base investing decisions and strategies on yield to maturity more so than coupon rates. 
Markets
Understanding Interest Rates, Inflation And Bonds
Get to know the relationships that determine a bond's price and its payout. 
Managing Wealth
Find The Right Bond At The Right Time
Find out which bonds you should be investing in and when you should be buying them. 
Managing Wealth
How Bond Prices and Yields Work
Understanding bond prices and yields can help any investor in any market.