In the first part of this post I said I would talk about what makes the price of bonds go up and down, and try to unravel some of the spaghetti linking the bond and stock markets. 

So let’s jump straight in. What causes a bond price to vary? Several things. One is how reliable people think the issuer is, i.e. what are the chances the issuer won’t be able to make the bond payments.

Ever heard the term ‘Junk Bonds’? Junk bonds are bonds issued by companies that people don’t think are all that reliable.

There are two main credit rating agencies, Moody’s and S&P, who issue credit ratings such as ‘double A’ or ‘triple B’ to issuers. The lower a credit rating the issuer has, the higher the risk of the issuer being unable to pay up and the higher the chance the bond holder will lose money. So low credit rated issuers have to pay a higher yield to bond holders to compensate them for the additional risk.

Of course credit ratings can change depending on a company’s status, and if a company makes a big loss one year its credit rating may be downgraded. That’ll cause the price of their bonds to drop and the yield to jump.

Of course credit ratings don’t mean much for major European or North American governments; the chances of these governments going broke are fairly remote. The main thing affecting the yields of Gilts and US T-Bonds right now, are inflation and interest rates.

Let’s do inflation first as that is the tougher nut.

To crack it we’ll use our previous  example in which Pensions-R-Us bought a bond with a par value of USD 1m for a 7% yield. They sold it 2 years later to ForSureForSure Insurance for a price of USD915,000 which gave a yield of 8.5%.

Now lets say that when Pensions-R-Us bought their bond inflation was around 2%. The yield they were receiving might have been 7% but their coupon payments and the USD 1m final payment were devaluing at 2% per year. So while on paper they were making a return of 7% their ‘real’ return was 5%.

A 5% return isn’t bad at all, but what happens if, over the two years that Pensions-R-Us held the bond, inflation rose to 3.5%? If that happened the ‘real’ return would have dropped and Pensions-R-Us would have had problems selling the bond. Now the bond’s coupons, par value and maturity can’t be altered so the only way Pensions-R-Us could get the real return back up to the 5% level that the market (or in this case ForSureForSureInsurance) would accept was to drop the price.

To summarise all of that in one sentence: rising inflation makes bonds less valuable – causing their price to drop and their yields to rise. However as with any other financial market, expectation is king. So bond holders won’t wait for inflation to actually rise; if they think inflation is going to rise, bond prices will fall and yields will rise.

Right now government bonds are even more sensitive than usual to inflation data so watch out for any inflation indicators – anything that hints at rising inflation in the UK is likely to push yields up.

The impact of changing interest rates is relatively simple. When a central bank puts up its interest rates what they  effectively say to the bond markets is that they will pay a bigger coupon (and hence the yield will probably be higher) on the next lot of bonds they sell. So if I hold a US Treasury Bond that is giving a yield of 5% and want to sell it, but the US Treasury is going to sell the next lot of similar bonds at around 5.5% would anyone buy my bond? Nope. Not unless I drop my price so that the yield on my bond is 5.5% too.

So there we have it. Three of the factors affecting bond prices are:

• The risk of the issuer (as measured by credit ratings)
• Inflation (and expectations of inflation)
• Interest rates (and expectations of interest rates)

I should point out straight away though that these factors are related. One of the main goals (sometimes the main goal) of central banks is to keep inflation low. If inflation starts to rise above a certain level they will try to push it back down again – by raising interest rates. So rising inflation can push up interest rates and bond prices are dealt a double-whammy.

However rising interest rates also have an effect on shares prices – especially on some companies. When interest rates go up they push up the cost of issuing new bonds, which means that companies have to pay more to raise the money they need to buy out other companies, launch new products, set up new factories and so on.

Higher interest rates also push up consumers’ mortgage payments. That can lead to a slow-down in the housing market which will hurt housebuilders (such as Wimpey and Kingspan) and banks that make a lot of money out of mortgages. It will also mean consumers will have less money to spend, which will hurt retail companies (M&S, Tesco), leisure and travel companies (Thomas Cook) and car manufacturers. For all of these companies rising interest rates can harm profits. Lower profits means lower share prices and, eventually, credit rating downgrades which as we said earlier leads to their bond prices falling and yields rising.

But interest rates don’t just influence company profits - they can also affect the demand for shares. This decade has seen explosive growth of two types of institution: private equity and hedge funds. Private equity firms typically borrow lots of money in order to buy out companies: notable examples have been the purchase of Eircom in Ireland and the nearly-complete pruchase of Boots in the UK. However if interest rates go up Private Equity firms will find it harder to finance new purchases (which means less M&A activity and less growth in share prices) and may lead to a tightening of belts in companies already owned by private equity partners. If you want any evidence of how Private Equity firms are affected by rising yields look no further than the recent flotation of Blackstone in the USA.

The term ‘hedge funds’ covers a multitude of different organsiations. To be brief about it though some hedge funds will use derivatives (including CFDs which are similar to spread bets) to invest in shares. In effect they are borrowing money to buy shares, which works well as long as they can borrow cheaply and share prices are going up. But if the cost of borrowing goes up they may need to sell some shares and reduce their borrowing. 

So at this point the relationship between the bond and stock markets should be pretty clear: when interest & inflation rates go up bond yields rise and stock prices fall. But could anything in the financial markets be that simple?

We also need to consider that central banks know full well that higher interest rates can subdue the economic growth - so they won’t raise interest rates unless they think the economy can take it. Looked at in this light you could argue that rising interest rates is actually a sign of a strong economy. And a strong economy means rising share prices. 

Yet another theory has it that investors only have a limited amount of money, and they split it between bonds and shares. So when they prefer shares (for example when inflation is rising) they’ll sell some bonds to buy more shares. And when they prefer bonds (for example when inflation is falling) they’ll sell a wad of shares to buy bonds.

Both of the last two points above point to a ‘when bond yields go up share prices go up’ relationship – the exact opposite of what we said above.

See why I named this article Bond Spaghetti!

And if you think we’ve got to the bottom of this subject, think again. There are plenty more issues, including the price that private equity firms can borrow to finance their takeovers, the impact of the risk free rate on company pricing models, the relative sensitivities of bonds vs equities to inflation and more. This post is more than complicated enough so I’m not going to get into any of the above – but some of these are mentioned in a recent FT article.

So which is it? When bond yields go up (as they are now) does this indicate share prices will go up or go down? As you’ve probably guessed by now, there’s no clear-cut answer. Infact the only question being more hotly debated is what has caused bond yields to rise so much in the first place!

Here’s my view, whatever it is worth (and I ain’t claiming it is worth much): there have been occasions in the past where the stock markets have seen yields increase and have kept growing without taking a blind bit of notice. However we’ve never seen private equity and hedge funds operating on the scale they do today, which I think means the stock markets will be more sensitive to interest rates than before. On the other hand companies are still doing pretty well. So I reckon we can watch yields rise up to a certain point and still expect some growth, if not the superb growth rates we’ve had in the last three years. However after that high yields over a period of 6 months or more are going to hurt the economy and push stocks down.

And that’s it. Didn’t I tell you when I started this article, back in 1973, that it was gonna be a challenge? Thanks for sticking with, and I hope that after reading this your brain isn’t hurting as much as mine is after writing it.

As always may the markets be with you.