With both the European Central Bank (ECB) and Bank of England Monetary Policy Committee (MPC) having left interest rates on hold, I thought I would dedicate this column to the effect of interest rates on bond prices.
An expected or unexpected change in interest rates can bring both positive and negative implications to the stock market. Bond prices in particular will react to such interest rate movements.
Gilt edged securities – which are also known as government stocks or government bonds – are the more familiar form of bond known to investors. A bond is a form of ‘I Owe You’ (IOU) issued by the government when it needs to borrow money. This IOU entitles the lender (investor) to receive a set level of income each year, for a specific period. At the end of this period, the borrower (government) promises to pay back the full capital loaned.
Let us assume that the government need to borrow money at a time when investors could expect to receive an interest rate of 6.50% from a gilt edged security. This means that the government would need to pay each investor 6.50% on the money borrowed each year until that particular gild-edged security matures. Consequently, for each £100 invested, you could expect to receive £6.50p per annum.
Let us now assume that interest rates rise to 7%, which means that investors would now expect to receive 7% or £7.00 for every £100.00 invested. Consequently, the gilt-edged security paying 6.50% would not be as an attractive proposition as the gilt-edged security paying 7%. This means that the price of the 6.50% security will fall to a level which equates to 7% of its new price. In other words, the price of the 6.50% security will fall to about £93.00.
Whilst the value of the gilt-edged security has fallen due to interest rates rising, had interest rates fallen the price of the gilt-edged security would have risen.
The fact that both the ECB and MPC did not alter their rates did not come as too much of a shock to the stock market. Much comment is given on the outlook for interest rates in financial papers. This is because high interest rates mean higher borrowing costs for companies and individuals alike, as well as potential losses for existing investors in fixed-interest bonds.
The name’s Bond
The movement in bond prices is, of course, not just as a result of moving interest rates and, as such, is a little more complex than this article suggests. For example, stock markets tend to look ahead and build-in future events. If investors feel that interest rates are going to rise, then they may start selling which, in turn, will bring down the bond price. Alternatively, if they feel that interest rates are going to fall, investors will start buying as this will give them an instant profit when interest rates do eventually fall.
Bond funds are an excellent way for investors to obtain a good level of income. However, the level of interest (income) being offered by the bond fund should reflect the level of interest currently available from, for example, the Bank of England. A rate greatly in excess of that which is available from the Bank of England will mean that you are placing your capital at too much risk.
If you are looking for income which does not place your capital at undue risk, I would recommend that you give consideration to a fund which is currently offering income in Euros of 5.40%. For more information, telephone 96 577 15 00.
Since its launch in June 2003, a property fund which invests in property in Spain, has returned an astonishing 9.60%. The minimum investment is only Euro 25,000. In addition, this fund offers an annual withdrawal of 7.50%.