Investors routinely turn to bonds when they want an investment that will provide predictable streams of income. Because the most important aspect of a bond is how much interest it pays, many investors don't think much about the actual price of a bond. Instead, they tend to trade bonds based on the yield that they offer. When you're buying a bond, knowing the difference between the bid yield and the ask yield is essential for two reasons: to gauge the liquidity of the bond market, and to avoid making mistakes about your expected return when you buy the bond. Below, we'll take a closer look at the bid and ask yields to explain the differences between them.
Bid vs. ask and why yields 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 those two numbers is known as the bid-ask spread, and in general, the narrower that spread, the more liquid the market is.
In the bond market, you can see this difference in various markets. Treasury bonds are extremely liquid, so bid-ask spreads tend to be narrow. By contrast, markets for certain corporate bonds are less liquid and carry wider bid-ask spreads.
However, bond quotes are often given in terms of yield rather than price, because the yield tells the expected return on the bond through maturity. The bid yield is the yield figure that you get when you consider what your long-term return would be if you paid the bid price for the bond. Conversely, the ask yield is the figure that results when you do the same calculation based on the higher ask price.
Bid yields are always higher than ask yields, because if the buyer were willing to take a yield that was equal to or less than the ask yield, then the seller would sell the bond to the buyer at that 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 familiar with trading in the stock market than in the bond market. The concept of bid and ask yields might sound complex in theory. In practice, though, the figures give you an idea of what returns you can expect on a bond investment.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!
