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 paragraphTwo big forces move every bond and every bond fund at once: interest rates and inflation. When interest rates rise, bond prices fall. When inflation rises, the fixed payments a bond makes buy less, and interest rates often rise in response. Neither depends on any one borrower. Both affect the whole market.
Most people hold bonds through a fund, and a fund spreads the risk of any one borrower failing across many. What a fund cannot spread away is what happens to the whole market. This chapter is about those two forces, and what each one does to the money you invest.
What happens when interest rates rise?
When new bonds start paying more, existing bonds paying less become less attractive, so their prices fall. Chapter V shows why with the see-saw. A bond fund's price is worked out every day from the prices of the bonds it holds, so a fund falls as soon as rates rise. There is no end date when it simply pays you back.
How far it falls depends on duration: the longer the loans in the fund, the bigger the move.
| Interest rates rise by one percentage point | about £950 |
|---|---|
| Interest rates stay the same | about £1,000 |
| Interest rates fall by one percentage point | about £1,050 |
A fund with an average duration of 10 would move roughly twice as far, either way.
Why do interest rates rise?
- To bring inflation down. The Bank of England raises Bank Rate when prices are rising too fast. Bond yields usually rise with it.
- Because lenders want more. If lenders doubt a government's borrowing plans, they ask for more interest, especially to lend for a long time. Chapter II calls this the market pricing cost and credibility.
- Because of supply and demand. When a government needs to borrow much more, it has to sell more gilts, and buyers may only take them at higher yields.
Rates can also fall, for the opposite reasons. Then bond prices and bond fund prices rise, although new money invested earns less.
What does inflation do?
A conventional bond pays a fixed amount. Every payment arrives in full, but if prices in the shops rise meanwhile, each payment buys a little less than the one before. The £1,000 repaid at the end also buys less than the £1,000 you lent.
| Repaid to you in five years' time | £1,000 |
|---|---|
| What it will buy, in today's money | about £863 |
The same is true of every £50 interest payment along the way: each one buys a little less than the last.
How do the two forces connect?
They often arrive together. Higher inflation tends to push interest rates up, and higher interest rates push bond prices down. So a bond can be hit twice: its payments buy less, and its price falls. When inflation eases and rates come down, the same thing works in reverse.
Index-linked gilts, covered in chapter III, raise their payments with inflation. That protects what the payments buy, but their prices still fall when interest rates rise.
Can a fund do anything about it?
An actively managed fund can shorten its average duration when the manager expects rates to rise, so that a rise does less damage, and lengthen it when the manager expects rates to fall. A tracker fund cannot. Either way, managers can be wrong, and there is no certainty that any fund avoids a fall.
Risks tied to one borrower, such as a company failing or a bond being repaid early, are covered in chapter IV. In a fund they are spread across many borrowers.
Test yourself: guess first
Pick an answer, then read why. There is no score, and nothing is recorded.
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Interest rates rise. What happens to the price of a bond fund?
It goes down. New bonds pay more, so the bonds the fund already holds are worth less, and the fund's price is worked out from them every day.
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Interest rates fall. What happens to the price of the bonds you already hold?
It goes up. Your bonds now pay more than new ones, so buyers will pay more for them.
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Prices in the shops rise every year. Is the £50 you are paid in year five worth the same as in year one?
Less. The payment stays at £50, but it buys less each year.
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Rates rise by the same amount. Which falls further: a fund of two-year bonds, or a fund of twenty-year bonds?
Twenty-year bonds. Longer loans have a longer duration, so their prices move further when rates change.
Where next?
You have now read the whole book. If you decide bonds or bond funds have a place in your plans, the appendix explains where people buy them. If you are unsure whether an investment is right for your circumstances, consider regulated financial advice.