By DUNCAN SCOTT 08/01/2010
In its most basic form, a bond is a debt (or loan) issued by governments or companies in order to finance long-term investments. The holder of the bond will usually receive an interest payment at fixed intervals and a capital repayment upon maturity of the bond.
The price of a bond is the present value of all expected future coupon payments and capital payment, discounted at the redemption yield. The key aspect to this statement is the word ‘expected’ and it is these expectations that drives bonds prices to change in value. Below we look at the some of the key factors that drive bond prices.
Interest rates
The first and perhaps most influential driver of prices is the expectation of interest rate movements. Typically, if interest rates fall the price of bonds should rise. This is because the fixed yields on bonds will now be relatively higher than the interest on cash so demand for bonds rises. This increase in demand raises the price. For example: A bond paying a 5% coupon is not an attractive investment if interest rates are 6%. However, if interest rates fall to 3%, the bond looks more attractive and demand for it rises, also pushing up the price of the bond.
Inflation
A second important factor in bond pricing is the expectation of future inflation. In the same vein as interest rates, when inflation is expected to fall, the price of bonds will rise. This is due to the coupon now having a higher real return and therefore demand will again increase.
Exchange rates
Exchange rates can also affect the bond price. For example, if sterling is struggling against other currencies the Government may use monetary policy to increase interest rates. This makes sterling more desirable for overseas investors and strengthens the currency, but has the effect of lowering the price of bonds.
Issuers performance
On a more microeconomic level, the market for Corporate Bonds is driven by the financial performance of the company issuing the bond. If rating agencies become less confident about the firm’s ability to repay the loan upon maturity, they will lower the credit rating. This will cause the price to fall as investors become less sure that they will get their money back when the bond matures.
Our view
Corporate bonds were hugely successful in 2009 as confidence returned following the financial crisis. Investors turned to bonds as an income source and a place to invest away from equities. Bonds were helped by falling interest rates and inflation, but as capital values have recovered and with expectations of interest rates rising in 2010, we believe the best opportunities are now in strategic bond funds which can now invest across the whole of the market.
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