What Drives Price Movements in Government Bond Prices?

9th January 2011

In August 2010 the yield on the US 10 Year Treasury bond hit a low of 2.4% having previously hit a high of 15.7% in September 1981. Big swings indeed but what drives these movements, what do theyimply about the economy and where are prices likely to head?

Basics

A government bond is a bond issued by a national government denominated in the country's own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds. The first ever government bond was issued by the English government in 1693 to raise money to fund a war against France. Government bonds are usually referred to as risk-free bonds, because the government can raise taxes to redeem the bond at maturity. Some counter examples do exist where a government has defaulted on its domestic currency debt, such as Russia in 1998 (the "ruble crisis"), though this is very rare. As an example, in the US, Treasury securities are denominated in US dollars. In this instance, the term "risk-free" means free of credit risk. A bond is a formal contract to repay borrowed money with interest at fixed intervals.

Very simply, treasury bonds are tools for governments to raise funds at a fixed rate. So, for instance, if the UK government issues a 5 year £100 bond with a coupon rate of 5%, it will pay interest of 5% p.a. over the life of the bond. These bonds are, however tradeable, over the market and, as with shares, their price will vary from the issue price (£100) according to various market forces.

This price variation will affect the yield of a bond which is calculated as interest/price. This means that on issue the yield is:

• 5/100 = 5%

But if the price drops to £95 the yield becomes:

• 5/95 = 5.26%

Note, that regardless of the price the bond will always pay the interest amount originally stipulated i.e. 5% of the original £100 face value of the bond. Hence, the relationship between yield and price is inversely proportional.

What Affects the Price of a Bond?

1. Interest rates

The over-riding rule is that when interest rates go up, bond prices go down and vice-versa.

This is a relatively easy rule to understand. If a bond yield is presently 5% and the general rate of interest is 7% then bond yields will look relatively unattractive and the price of the bond will fall leading to a corresponding rise in the yield - evening out the discrepancy. So in this case if you expect interest rates to rise, you would also expect a corresponding decrease in bond prices and the accompanying rise in their yields.

2. Inflation

Rising inflation is a threat to the real value of bonds because, in our example, the buying power of £100 invested in bonds will be diminished by inflation over time and the income it generates becomes progressively worth less in real terms. So the result of this is:

• When inflation starts to increase or is anticipated to increase, bond prices fall and yields increase.
• When inflation reduces or is expected to reduce, bond prices increase and yields fall.

3. Exchange Rates

Exchange rate activity can affect bond prices indirectly since central banks will often seek to readdress movements in their currency by adjusting interest rates. So for instance if the pound became significantly stronger against other currencies and this was damaging the UK export trade the Bank of England may seek to drop interest rates to weaken the pound and correct the imbalance. Any change in interest rate will, as we explained in point 1, affect the price and yield of bonds.

Bear in mind also that exchanget rates will also play a part in determining the returns of parties investing in foreign government bonds. As they are always denominated in the home currency, a foreign investor could see his returns hit by any weakening in their exchange rate relative to the currency of the issued bond.

4. Economic Factors

One of the clearest examples of the economic factors affecting the price of bonds has been the credit crunch and the rush of funds into the safety of government bonds. This led to rise in the price of treasury bonds and the subsequent falls to record lows of government bond yields.

The flip-side of this has, however, been with those nations for whom the economic collapse has been structural and the security of government debt itself has been brought into question. Here we are looking specifically at the PIIGS (Portugal, Ireland, Italy, Greece,Spain). The underlying issues facing these governments have led to the market appetite for treasury debt to decrease and the price has subsequently dropped. This was further exacerbated by the knowledge that each of these countries is a member of the Euro and has limited scope to employ independent monetary policy in correcting their domestic woes.

Table 1 - Government Bond Yields, 10 Year Notes (7th Jan 2011)

The data in Table 1 shows the present state of play in relation to some of the world's leading countries and their 10 year bond yields.

Noticeably, the PIIGS are all showing evidence of the high risk status of their national debt through the high yields on their bonds. At the other end of the spectrum there are two of the currently more steady economies of Japan and Switzerland who are currently enjoying low interest rates and low inflation.

Portugal has itself just had to pay a high premium in its latest fund-raising exercise. The government has committed to an average yield of 3.68% on a €500m issue of 6 month treasury bills which is a significant increase from yields of 0.59% of just one year ago. This brings with it other worrying signs as a rising cost of debt can slow growth which could then force yields even higher.

But what of the US and the UK? These are, to say the least, interesting times and commentators are proposing a variety of views on both. Most views do however centre around national debt, quantitative easing, interest rates and inflation.

Recently the bond dealers have switched to selling as have the foreign central banks. With yields at historic lows the expectation is that this cannot continue and that prices will fall. With increased quantitative easing in the US, as more money is printed, observers will argue that either inflation will rise or that the US can't pay off its ever increasing debt mountain. Both scenarios lead to a rise in bond yields.

An argument, which is gaining more support, is that the US economy is improving faster than expected and that tighter monetary policy is on the horizon. The accompaniments to this will be a rise in the equity markets and a subsidence in bond prices in 2011.

The bulls will however argue that the underlying weaknesses in demand which accompany high unemployment levels and, indeed, a perception that these levels will not improve quickly means that a sustained rise in the rate of inflation is not likely.

Whilst inflation has been seen to creep up in recent months in both the US and UK much of this is related to food and energy prices and that these rises will surpress any price increases in other sectors as disposable income is taken up with necessities. So whilst there is currently a lot of talk about decreasing bond prices this is not, by any means, a certainty.