Revision on Bond Markets
Bonds are debt securities sold by governments, companies and banks in order to raise capital.
They do not confer a share of ownership of a company – in contrast to equities.
They normally carry a fixed amount of interest known as the coupon and they have a fixed
redemption value (i.e. the value repaid at the date when the bond matures).
When a bond matures, it is redeemed (repaid) at a pre-determined par value – say £100.
In the UK, government-issued bonds are known as gilt-edged securities (the secondary market
where they are traded is called the gilts market)
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Short bonds have a redemption date of less than five years
Medium-dated bonds have a redemption date of 5-15 years
Long-dated bonds have lives of over 15 years
Some bonds such as console or war loans are undated – irredeemable
Bond prices and interest rates
For bonds which pay a fixed interest (coupon) per year - there is an inverse relationship
between interest rates and the price of bonds.
Say for example we have a 10 year bond each issued at £1000 paying a fixed coupon of £40 per
year – the coupon becomes the effective yield (or rate of interest) on the bond. In this case, if the
price of the bond stays at £100, then the yield is 4%. However if the price of the bond rises to
£110, then the yield = (£40/1100) 100 = 3.63%.
The real value of a bond is driven down by the effects of inflation – this is especially the case
when we look over a long time horizon of ten years or more. Therefore long-dated gilt prices tend
to move in the expectation of changes in interest rates and inflation. Worries about a return to
higher consumer price inflation might drive bond prices down and long-term interest rates up.
This matters for the economy because many other interest rates are linked in part to the yield
(interest rate) on longer-dated securities – for example mortgage interest rates take their cue
from the bond market. And, if long-term interest rates go up, this makes it more expensive for a
government (operating through a central bank) to finance its own borrowing.
The yield curve
The yield curve is a way of comparing rates of return on bonds of differing maturity. Normally we
would expect yields on long-dated bonds to be higher than for short-dated securities – because of
the risks of inflation going forward). There are occasions though when the yield curve can become
‘inverted’ - this means that short term interest rates are greater than on long-dated bonds.
Conventionally this is a sign of a slowdown or a recession because it is a sign that the bond
market is expecting lower interest rates in the future – perhaps as a result of an economic
downturn.
As well as looking at the yield curve, many investors look at the yield gap – which is the difference
between the yield on long term bonds and the dividend yield on shares.
What has been happening to bond interest rates recently?
UK Government Bond Yields
Daily yields, per cent
14 10 Year 4.41
Percent
13
14
2 Year 3.899
20 Year 4.61
13
12
12
11
11
10
10
9
9
8
8
7
7
6
6
5
5
4
4
3
3
88
89
90
10 Year
91
92
2 Year
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
08
20 Year
Source: Reuters EcoWin
Notice the high bond
interest rates in the late
1980s – this was when the
UK last had a major
inflation problem
Bond yields have come
down a lot over the last
ten-15 years – a reflection
of a shift towards lower
inflation + inflows of
foreign exchange into the
UK economy buying UK
bonds – driving prices
higher and bond yields
lower
Bond yields picked up
again in 2006-07 –
possibly reflecting fears of
renewed inflation – now
heading lower – fears of
recession?
And also driven higher
because of the rising size
of the government budget
deficit.
Bond Yields and Short Term Rates
Daily yields, per cent
7.0
7.0
6.5
6.5
LIBOR 3 month rate (%)
Percent
6.0
6.0
BoE Base Rate
5.5
5.5
5.0
5.0
4.5
Short term rates still
above long term rates – a
harbinger of a recession
for the UK?
4.5
Yield on 10 year bond
4.0
4.0
3.5
Jan
This chart shows the
difference between short
term interest rates and
longer-dated securities –
students of the credit
crunch will recognise the
disconnect between LIBOR
and the base rate
3.5
Mar
May
Jul
Sep
Nov
Jan
Mar
May
06
Government Benchmarks, Bid, 10 Year, Yield, Close, GBP
Policy Rates, Bank Rate
Interbank Rates, LIBID/LIBOR, 3 Month, Average, GBP
Jul
07
Sep
Nov
Jan
Mar
08
Source: Reuters EcoWin
Notice that base rates
have fallen three times
since December but the
LIBOR rate is still stuck at
around 6% because of the
liquidity crisis created by
the credit crunch.