Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
The link between the stock market and what’s going on in the real world is intuitive. If the news is good you expect prices to rise; if bad, the reverse. This is why the FTSE 100 or Dow Jones index is often used on news bulletins as a kind of shorthand for the mood in the markets.
When it comes to bonds, it’s not so simple. The relationship is less obvious for a couple of reasons.
The first is a technical one - when people talk about bonds they tend to refer not to their price but the yield they offer investors. We say, for example, that the 10-year Treasury bond yields 0.9%. Because the yield moves in the opposite direction to the price (for a reason I’ll explain shortly) as the holder of a bond you will cheer a fall not a rise in the yield.
The second, related, difficulty is that in the bond world bad news in the economy can be good news for the value of an investment. When businesses and households are struggling, expectations for inflation and interest rates can fall. This tends to push bond yields lower too. And, because of the first reason above, this will boost the price of a bond.
So why do yields fall when news is bad and rise when news is good? It’s to do with investors’ expectations about the future and the compensation they require for lending their money to a company or the government in an uncertain world.
A bond is simply an agreement that a borrower will pay a lender a set amount of income on a regular basis for a pre-determined period of time, at the end of which they commit to repaying the amount they have borrowed.
The willingness of the lender (investor) to lend for the agreed income is influenced by a couple of things.
First, it reflects the income that an investor could earn with a no-risk investment such as cash. This in turn is determined by interest rates. So, if interest rates fall then so too will bond yields and vice versa.
Second, an investor will be more inclined to lend if they expect inflation to remain low until the bond is repaid. This is because the repayment amount, and the income payments in the meantime, are fixed. If inflation is high, then the money repaid will be worth less to the lender when they finally receive it. They are likely to require a higher yield to compensate them for that potential loss.
This also explains why bond yields tend to be higher on longer-dated bonds. There is more time for things to go wrong so investors want a higher yield to make up for that risk.
Now, let me explain that bit about yields and prices moving in opposite directions. As I’ve explained, the income promised by a borrower to a lender is fixed at the outset. Let’s say it is 3p for every 100p bond issued. As long as interest rates are 3% then a lender is no better or worse off holding the bond than putting the money in the bank.
But what if interest rates rise to 5%? In this case a potential buyer of that bond is unlikely to be very interested. Why take 3% from the bond when they can earn 5% in a deposit account? In order to make the bond competitive, the price needs to fall until the 3p income represents a 5% return on the new price. 3p is 5% of 60p, so the value of the bond needs to fall quite far in order to tempt new buyers.
I should say, at this point, that this is a simplification. The influence of changes in interest rates on the value of a bond is also determined by the amount of time left until the amount borrowed is repaid. The inflation rate is a bigger influence on long-dated bonds than ones that are due to be repaid in a couple of years. That’s because inflation has more time to weave its malign spell on the value of the bond.
Changes in interest rates also have more impact on a longer-dated bond. For a bond due for repayment next year, the biggest influence is the amount of capital to be repaid not the income that will be received in the meantime.
This means that changes in interest rates and inflation expectations have a different influence on a 2-year bond than a 30-year bond, for example. But I’m in danger of losing myself let alone readers at this point, so I’ll leave it there. If you ever here the word ‘duration’ then this is what’s being discussed. Don’t worry too much about it.
All we need to know for now is that rising inflation expectations and rising interest rates will tend to push bond yields higher and so bond prices lower. And that, as it happens, is what investors are expecting today.
One of the key reasons for this was lost last week in the coverage of the attack on the Capitol building in Washington. The attack coincided, indeed was possibly triggered by, news that the Democrats had won the two Senate seats in Georgia that November’s election had left unfilled.
That was important because it took the balance of power in the Senate to 50:50. And with new vice president Kamala Harris’s casting vote, that means the Democrats now enjoy a slender control of the Senate to add to their majority in the House of Representatives and, of course, Joe Biden’s move next week into the White House.
This matters to the bond market because Mr Biden wants to enact a programme of further fiscal stimulus - more government spending to add to the $900bn agreed just before Christmas. With control of both houses of Congress, there is a good chance that he will be able to push through that agenda.
More spending means more growth, and probably more inflation. And, as we have seen, that is likely to lead to higher interest rates and higher bond yields. Unsurprisingly, we have already seen bond yields start to rise in anticipation of those developments. The 10-year US Treasury bond, the cornerstone of the bond market, which yielded around 0.5% last summer, now yields more than 1.0%.
If you have a balanced portfolio that includes bonds and shares this could be interesting for a couple of reasons. First, it means that the value of your bond holdings is under pressure.
But second, it could also have an influence on the value of your shares. Why? Because just as the income available on risk-free cash influences the yields on bonds, so too does the yield on bonds influence the value of alternative investments such as shares.
Be careful, though. The relationship is not always what you might expect. On the face of it, rising bond yields make shares less relatively attractive. If you can get a higher yield on a government bond why would you take the extra risk of holding a company share when the dividend income that it offers you is variable and not guaranteed?
But it is also true that some of the money which has been parked in apparently safe bonds in recent years may start to look less safe if bond prices are falling. We might expect some of that money to find its way into the stock market if the outlook for shares is improving thanks to all that extra government spending.
I’m sorry if this is a bit complicated - and long. Unfortunately, investors who have been able to ignore the bond market for many years may now need to keep a closer eye on it. So, I thought it was worth explaining things in a bit of detail.
We’ll try and help you get to grips with bonds in future articles too. In the first instance, you might want to take a look at the new quarterly Investment Outlook here. The section on asset classes in the report includes our latest thinking on bonds as well as shares, property and commodities.
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Due to the greater possibility of default an investment in a corporate bond is generally less secure than an investment in government bonds. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.