The difference between long and short yields on bonds
Investors regularly turn to bonds when they want an investment that will provide them with predictable income streams. Since the most important aspect of a bond is the amount of interest it pays, many investors don’t think much about the true price of a bond. Instead, they tend to trade bonds based on the yield they offer. When you buy a bond, knowing the difference between the long yield and the short yield is essential for two reasons: to assess the liquidity of the bond market and to avoid making mistakes about your expected yield when you buy the bond. Below, we’ll take a closer look at bidding and yield demand to explain the differences between them.
Supply versus demand and why returns matter
With many investments, the concept of bid and ask applies to prices. The bid price is what a buyer is willing to pay for a security, while the ask price is what a seller is willing to accept for the same security. The difference between these two numbers is known as the bid-ask spread, and in general, the narrower the spread, the more liquid the market.
In the bond market, you can see this difference in different markets. Treasury bonds are extremely liquid, so bid-ask spreads tend to be narrow. In contrast, the markets for some corporate bonds are less liquid and have wider bid-ask spreads.
However, bond quotes are often given in terms of yield rather than price, as the yield indicates the expected return of the bond to maturity. The bid yield is the return you get when you consider what your long-term yield would be if you paid the bid price for the bond. Conversely, the requested return is the number obtained when you perform the same calculation based on the highest asking price.
Bid yields are always higher than ask yields because if the buyer was willing to take a yield equal to or less than the ask yield, the seller would sell the bond to the buyer at the corresponding price. As with bid and ask prices, the spread between bid and ask yields is wider when markets are illiquid and narrower when there is a lot of trading activity.
Most investors are more used to trading in the stock market than in the bond market. The concept of bid and ask yield can seem complex in theory. In practice, however, the numbers give you an idea of the returns you can expect from a bond investment.
This article is part of The Motley Fool Knowledge Center, which was created based on the wisdom gathered from a fantastic community of investors. We would love to hear your questions, thoughts and opinions on the Knowledge Center in general or on this page in particular. Your contribution will help us help the world invest, better! Write to us at knowledge firstname.lastname@example.org. Thank you – and crazy!