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 bond market – which determines the interest rate at which the government, and ultimately the rest of us, can borrow – has been on the front pages in recent weeks. This is rarely a good sign.
That’s because few people understand the bond market, so newspaper editors need an especially powerful reason to give them prominence. Only if the news is sufficiently bad are they likely to be persuaded.
So: the bond market is important but poorly understood. This article will attempt to explain why they matter and how they work.
Why do the bond markets matter?
In a nutshell, they set the global cost of borrowing for everyone. This means that what you pay in interest on your mortgage, personal loans and so on is largely determined by the bond market. Their influence on your personal finances is therefore obvious, but their importance does not end there.
Companies and governments also borrow, and the interest rates they pay affect everyone, indirectly at least. If companies have to pay high interest rates to fund themselves, economic growth tends to suffer. After all, if a business wants to expand and needs to borrow to build, say, a new factory, too high an interest rate might make it think again. When the government has to pay more to borrow, the extra interest costs can mean less money for the NHS, schools, benefits and so on.
Even that is not the end of the bond markets’ influence on our lives.
The returns that investors can make from bonds are judged in relation to those available from other assets, such as shares. If the yield on government bonds rises, it makes them more attractive and will tend to pull some money away from the stock market, exerting downward pressure on share prices. Yields on 30-year gilts (bonds are called ‘gilts’ if they are issued by the British Government) came close to 6% earlier this month, a level that many investors will find appealing. Shares that pay a high dividend yield are especially affected by movements in the bond market because a direct comparison can be made between their yield and the gilt yield.
The chart below plots changes in gilt yields against changes in share prices. Although the correlation is not perfect, you can see that falls in the stock market often coincide with rises in the gilt yield. Correlation seemed stronger in the period before the beginning of April this year, when the tariff war sparked turmoil in financial markets.
Another way in which the bond markets can directly affect our standard of living is via their influence on annuity rates. When you buy an annuity, the insurer tends to put your money into gilts as a means to provide the flow of cash with which to pay you your income. When gilt yields rise, the insurer can pay you more. In other words, when gilt rates rise, annuity rates follow suit, and annuity buyers are currently enjoying some of the highest rates in years.
An American public figure memorably expressed the power of the bond markets in 1993. James Carville, Bill Clinton’s political strategist, said: ‘I used to think that if there was reincarnation, I wanted to come back as the President or the Pope … But now I want to come back as the bond market. You can intimidate everybody.’ In April this year the bond markets were credited for Donald Trump’s decision to delay implementation of his new tariffs, as we explained in our article Bond market overpowers Trump tariffs. How does it work?
How the bond market determines mortgage rates
How does the bond market determine interest rates on, say, mortgages? We need to break the answer down into two parts.
First, what the market sets directly is the rate at which the government borrows from investors such as asset management firms and pension funds. These investors buy and sell government bonds among themselves and the price at which the bonds trade determines in turn the ‘yield’: the interest paid by the bond, in pounds, divided by its market price, also in pounds. A higher price means a lower yield and vice versa.
When the government wants to borrow by issuing a bond (which it needs to do frequently, both to finance more spending and to allow the repayment of existing bonds as they mature), it has to offer an interest rate competitive with the yields available in the market. For example, the ‘benchmark’ 10-year gilt yields 4.6% at the time of writing. If the government tried to sell a new 10-year bond that paid 4%, it would not get any takers because potential investors would buy existing 10-year bonds on the open market instead and get 0.6 percentage points more yield each year.
The second part of the answer is how the yield on government bonds affects other interest rates. The key to this is simply that the government is the safest borrower around, so it pays a lower rate of interest than anyone else. After all, the government could, in extreme circumstances, tell the Bank of England to print the money it needed to pay off bondholders. You and I as mortgage borrowers have no such ability. If anyone else wants to borrow money, they need to pay more interest than the government, and the premium they have to pay on top of the gilt yield will reflect how risky a borrower they are.
Why are the bond markets making headlines now?
In a word, because interest rates – in other words, bond yields – have been rising, in some cases to levels not seen previously this century. (The Bank of England sets short-term interest rates via its Bank Rate but long-term interest rates are determined by the bond market in the way described above.) These higher rates put more pressure on the government’s finances; in particular, if the Chancellor wants to meet her ‘fiscal rules’, she may have to consider tax rises or spending cuts for her Budget on 26 November.
Read: What can we expect in the Autumn Budget?
Some mortgage rates have already started to rise in response to higher gilt yields. When Nationwide Building Society announced higher rates last week, one mortgage specialist said it marked ‘the beginning of the end of the super low rates’, the Newspage news agency reported.
Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. 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. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.
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