Gilts and bonds

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10. Factors which affect bond prices

1. Interest rates

   If you remember only one thing about bond prices, make it this:

   'When interest rates go up, bond prices go down, and vice versa.'

   To see why this is so, imagine you own a bond paying 6% interest. If interest rates are 4%, your bond's 6% looks attractive. If general interest rise to 8%, your bond's 6% looks unattractive. To adjust for this, the bond price falls, making the yield competitive.So as an investor, the best time to buy bonds is when interest rates are high but are about to fall. That way you will be buying at low market prices and high yields. If interest rates fall, the value of your bonds will rise and you will have a potential capital gain.

2. Inflation

   The other major influence on bond prices is inflation. Rising inflation is damaging to bond prices, because, unless the bonds are index-linked, the income they generate will fail to maintain its buying power. To compensate for this dwindling buying power, prices of the bonds typically fall.

   • When inflation is on the increase, bond prices fall, and yields rise.
   • When inflation is decreasing, bond prices rise, and yields fall.

   The threat which inflation poses to bond prices was evident in the 1970s. A £1,000 investment in gilts in 1970 was worth only £682 in real terms by the end of the decade, even with all income reinvested tax-free!

3. Exchange rates

   Exchange rates affect bond prices because if, for instance, the pound is struggling against other currencies, the Bank of England may feel it necessary to increase interest rates.

4. Corporate cash flow

   With corporate bonds, there is another factor: the financial performance of the company and the cash it is generating. Bond analysts like to know that their debtor is generating enough cash to comfortably service the debt. If one of the ratings agencies downgrades a company's creditworthiness to below investment grade (BBB), the price of the bonds is likely to fall.

1. What are bonds? 2. Different types of issuer 3. Different types of bond 4. Bonds compared to shares 5. Bonds as tradeable instruments 6. Nominal yield 7. Calculation of current yield 8. Capital gains on gilts and bonds 9. Calculating the redemption yield 10. Factors which affect bond prices 11. Are bonds for you? 12. Selecting gilts and bonds 13. How to buy gilts and bonds 14. Unit trusts and bond funds 15. Keeping track of your bond investments 16. Tax 17. Conclusion

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