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Lesson 9: Bonds

# Introduction to the yield curve

Introduction to the treasury yield curve. Created by Sal Khan.

## Want to join the conversation?

• How does the rate change when investors sell to each other? Say, for example, there is high demand when a 1-month bond is auctioned by the gov. and the rate is 0.5%. If the market then became scared and investors tried to sell their bonds on, people would only buy them for a higher interest rate (say 1.5%). However, my question is: where does this extra interest come from as the US treasury can't increase its interest payments on the original bond as it is not involved in this 2nd transaction?
• You buy a new 1 year bond of \$1000 that has a fixed interest rate of 0.5%. Now, if you hold it to maturity, you'll end up getting \$1000+\$5.

The next day, new 1 year bonds get auctioned for 1%. If someone bought one of them and held it to maturity, they'd get \$1000+\$10. Now, noone would be willing to pay you \$1000 anymore for your 0.5% bond as they can get better ones from the auction.

You need the money, so you end up selling the bond in the secondary market for \$995. The bond still pays \$1000+\$5, but now it would be comparable to a bond with a face value of \$995 that would pay \$10 in interest. So, the extra (or lowered) interest is due to the difference between the amount it was sold in the secondary market and the principal amount that gets returned to you at maturity.

By scaling the secondary market value to \$1000 (1.005*995 = 1000, 1.005*10=10.05) you can compare the bond to a new one (ignoring the fact that this bond would mature one day earlier). That is, the secondary market price of \$995 compares to a bond with a face value of \$1000 and a fixed interest rate of 1.005%.
• Why wouldn't all bidders at the auction bid really low, so as to receive a more valuable yield rate? It seems there are other influences that determine the yield of an issue at an auction. Any help or references?
• supply and demand... and also, if you and everyone else decided to bid low, and i KNOW of your collective intention to bid low, then I have an incentive to bid slightly higher, so that I would end up getting the bond, but at a very favorable price. Now since you and everyone else know that some people like me will try to take advantage of the collusion system AT YOUR DETRIMENT (because there will be fewer bonds for you to buy), or "cheat", then it makes no sense for you or anyone to collude for artificially low prices.
• So if the US government has to pay for example 4% for a twenty year bond, does that ammount fluctuate after it is sold? Why i ask is because when the US's credit rating got downgraded they said the bad thing was thiei interest payments would go up. I wasnt sure if that was only for future bonds or currently issued ones as well.
• The answer to your question, minus the politics, is no the rate does not change. The price that the bond is sold at, at auction ( new bonds ), will fluctuate but the bond will continue to pay the " coupon amount " ( the stated rate of return on the bond ) Also, the " Face Value " of a treas. bond does not change. They will mature at par or 1000 per bond. The concern was that the yield it would take to get people to buy bonds would be much higher, costing the government more to borrow funds on newly issued debt.
• If the USA's credit rating has dropped then whyis the intrest rate still so low.
• The USA"s credit rating is the opinion of a particular ratings agency. The interest rate on US treasuries is the entire market's opinion on the credit worthiness of the USA. These two sets of opinions rarely agree.
• Hey,
Just wondering, how come Bonds are seen as a safe investment, good for widows and orphans, when their price is subject to fluctuation?
• While their quoted price fluctuates day to day, their actual value does not change at all if held to maturity. If you hold a 10-year bond for 10 years, you will receive your full face value, exactly what you were expecting, when it matures. (that is assuming no defaults) However if you hold an equity for 10 years and then go to sell, the price could be drastically higher or drastically lower. Also the payments on the bond are known with certainty, while the dividends of an equity can fluctuate.
• Hi Sal,

I have a small doubt with regard to Yield Curve and fed fund rate. Fed lends money to US government at Fed Funds Rate and US government always tries to keep the fed funds rate as low as possible.. (Even below zero thru Quantitative Easing). It is because US govt. can reduce its liability of its Repayment to Fed. But my doubt is.if the rates are keep decreasing.wont it affect the global investors in Treasury Bonds?? Who will be willing to invest for low rates? Pls crct me if m wrng..
• The Federal Reserve does not actually lend money at the Federal Funds Rate. In fact, the Federal Reserve rarely loans money directly to the U.S government at all. It normally will go onto the open market and buy the Treasury Bills from those who already bought it from the U.S Government.

The Federal Funds Rate is the rate at which the Federal Reserve wants banks to lend to other banks. Normally, the Federal Funds Rate is slightly higher than the rate set by Treasury Bonds, because there is more risk in loaning to another bank when compared with loaning to the U.S. Government.

The rate set by Treasury Bonds is found using a reverse-auction. That means that the government asks for money and gives the bonds to those who are willing to accept the lowest interest rate. (The Federal Reserve is not one of these investors.) Therefore, the global investors are the ones deciding the Treasury rates, and they will always be willing to invest for the rates which they decide.
• why is the quality so bad? :(
• Why does high demand for treasuries lower the interest rate?
(1 vote)
• High demand means higher prices. Higher price means lower yield, by definition.
• What is the meaning of yield curve flattening?
(1 vote)
• It means that the long term interest rate and the short term interest rate are moving closer together.
A "normal" yield curve has higher long term interest rates than short term rates, so usually a flattening of the yield curve is referring to the fact that the long term rates are coming down, although in principle it could be that short term rates are rising, or some combination of the two.

(There are times when the yield curve is not normal but is "inverted", with long term rates below short term. It's unusual to talk about "flattening" in that context but if you did you would be referring to some combination of upward-moving long term rates together with downward-moving short term rates. )