Before you readCapital at risk. The value of investments and any income from them can fall as well as rise, and you may get back less than you invest. This is information, not advice.
In one paragraph"The bond market" is not one thing. It is thousands of lenders, including pension funds, insurers, banks, fund managers and central banks, each buying and selling bonds for its own reasons. Together they decide what it costs a government or a company to borrow, and for how long they are willing to lend.
When you lend £1,000 to the UK government, you are not the only lender. You are joining a very large crowd, and most of that crowd are institutions, not people. Knowing who they are explains a lot about why bond prices move.
Who buys bonds, and why?
Each kind of lender wants something different from a bond. That is why the market can move in ways that look strange from outside.
- Pension funds have to pay pensions for decades to come. Long-dated gilts pay them a known amount far into the future, which helps them match what they owe.
- Insurers hold bonds to meet future claims. They value payments they can count on.
- Banks keep gilts as a store of money they can sell or borrow against quickly.
- Fund managers, including the managers of the bond funds you can buy, and hedge funds, buy and sell to try to earn a return. Some trade very actively.
- Central banks, including the Bank of England, have bought government bonds in large amounts in the past to influence interest rates, and can sell them again.
- Overseas investors and individuals like you make up the rest.
When one of these groups needs to buy or sell in a hurry, prices can move sharply, even if nothing has changed about the borrower.
Where are bonds bought and sold?
A bond is first sold by the borrower itself. This is called the primary market. The UK government sells new gilts mainly by auction, and companies sell new bonds through banks that find the buyers.
After that, bonds change hands between investors. This is the secondary market, and it is where most of the buying and selling happens. It is also where your bond gets its price if you sell before the end. Most trading is between large institutions through dealers, but gilts and many other bonds can also be bought and sold by individuals through an investment platform or a stockbroker.
Why does the bond market matter if I never buy a bond?
Because it is part of the economy's plumbing. You rarely see it, but a lot depends on it working.
- Government spending. Whatever the government spends beyond what it raises in tax is borrowed, mostly by selling gilts.
- Mortgages. The rate on a fixed-rate mortgage depends on what lenders themselves pay to borrow for that length of time, which moves with the bond market. When gilt yields rise sharply, new mortgage fixes tend to follow.
- Company finance. Companies borrow by selling bonds to pay for factories, technology and growth.
- Collateral. Institutions pledge gilts as security when they borrow from each other. If gilt prices fall fast, some of them have to find more security quickly, which can make prices fall further.
What does the market actually decide?
Two things: the cost of borrowing, and the credibility of the borrower.
The cost is the interest a borrower has to offer before lenders will buy its bonds. Credibility is how far lenders trust the borrower's plans. If lenders start to doubt those plans, they ask for more interest, especially to lend for a long time. They may lend for shorter periods only, or not at all.
This is how a government's borrowing costs can rise within a day of announcing its spending plans. Nobody sets that rate. It is the result of thousands of lenders each deciding what they want in return for their money.
Is there one interest rate?
No. The Bank of England sets Bank Rate, but that is one rate among many. Two-year borrowing, five-year mortgage fixes and thirty-year gilts all have their own rates, and they can move in different directions for different reasons. Chapter V explains how they fit together.
First, though, a closer look at the most common bond a UK reader meets: a gilt.