Thanks in advance to anybody taking the time to clear this up for me. Say I buy a 10 year Bond right now. As time passes and the bond gets within 2 years of its maturity, does the 2 year bond rate apply to it or am I going to be looking at the 10 year bond rates throughout its lifetime.
If you hold the bond the full ten years, the YTM (Yield to maturity) will be your return.
Soon after you buy the bond, its value will change as its YTM will reflect current market rates. Say the 10 year was bought at a 6% rate. With 2 years to go, and a 6% coupon, if the 2 year rate is 2%, that 10 year bond will price above face value, the extra 4% for each of two years will push the price up to get close to the 2 year yield.
Yes, the current yields for all old bonds with 2 years left will be pretty close to the current 2 yr rate. Since the coupons are fixed, it's the price that varies so the calculation results in the correct yield.
A bond is a promise of future payments, given in exchange for an immediate payment.
For example, consider a $10,000 bond bearing interest at at 5% paid semi-annually, and maturing in 10 years.
if you own the bond, you will receive $250 , twice a year, for 10 years. The last payment will be accompanied by the $10,000 value of the bond itself. These payments are fixed.
At one time, the paper bonds actually had coupons attached that one could clip off, and turn in at a bank to receive the interest payments. The coupons were marked with the cash value, in this case $250, and the date they could be redeemed. Doesn't happen much if at all these days; everything is electronic...
You can obtain this bond by paying an amount that is acceptable to the issuer. Since current interest rates are lower than this 5% rate, you would probably pay more than the $10,000 face value.
At any time, an owner of the bond can sell the future payments to some one else, in exchange for an agreeable amount of money. He might even sell individual coupons to different people, and the redemption to yet another. As interest rates change, the "agreeable amount" will change. But the issuer of the bond doesn't care, the payments going out stay the same...
Edit to address comment:
The periodic payments and redemption are fixed when the bond is issued. They never change.
Suppose Lower Slobbovia decides to issue a 10 year, $10,000 bond with interest at 5% per year, paid semiannually. In fact, they are promising to pay $250 every 6 months for 10 years, and pay $10,000 at the end of the 10 years. That is exactly what they will do, no matter what happens to interest rates. The only purpose of the bond rate is to set these semi-annual payments.
By the time the bonds are printed and get to market, interest rates have gone up a bit. Investors want to earn at least 6% per year from this type of investment. If you find the present value of the 20 payments, and the redemption, at a rate of 3% per period, you find that Lower Slobbovia will only get around $9,256.12 for each bonds. Nevertheless, they start paying the purchaser the $250 interest.
After 8 years, someone holding one of these bonds is in need of immediate cash. He can't wait for the next four interest payments and the redemption, so he offers to sell these future payments for cash at that moment. Fortunately for him, interest rates for Slobbovian-quality bonds have dropped to 4% per year. The present value of the remaining payments is $10,190.38, so that's what he will get when he sells it. But Lower Slobbovia doesn't care; it just keeps paying the $250 twice a year, and the $10,000 at the end to somebody.
TIPS would be a 10 year bond, also available in 5 and 30 year maturities too, where the face value will adjust every 6 months with the CPI and thus would be a bit of a different kind of bond that may be worth noting here. The coupon rate would be fixed when you buy it and the principal adjustments are taxable income so one has to be careful about what kind of account one holds these kinds of bonds.
There are more than a few 10 year bonds you could buy today. The bond could have been issued anywhere from 2004 to the last Treasury auction and thus may have more than a few different yields on it with various time frames. If you buy a 10 year bond that was issued in 2004, it will mature soon and thus not pay as much as one that was issued in 2013 that may have more times to still pay out. You could buy a 10 year bond that will mature in 2019 and thus have 5 years left to maturity and thus would likely have yields like 5 year bonds in terms of how it is priced. Thus, when say, "The 10 year bond" are you talking about a 10 year Treasury bond in the next auction, a 10 year TIPS or are you referencing something that is already out there?