If you buy a bond when it is issued, you pay a fixed price. However, after it is issued, you Understanding how can trade the bond with other investors, much like you can with shares. When you buy or bond prices can sell a bond in this way, its ‘market’ price will be affected by a number of factors. rise or fall Here we look at the four main influences on bond prices. 1. How interest rates affect bonds Now imagine that the Bank of England decides that The interest rates paid by banks and building societies the economy is growing too fast and decides to raise normally follow the official interest rate set by the Bank the official interest rate, causing the rate on the savings of England. The Bank of England uses this rate as a tool account to move up as well, to 2%. Suddenly, the 1.25% to manage the UK economy. on the bond doesn’t look as appealing, so its price is likely to fall. Equally, if the Bank of England cuts interest rates, When times are tough, interest rates tend to be cut in the the interest on the bond becomes more attractive, so its hope this will encourage consumers to spend, businesses to price may rise. borrow and, through this process, kick start the economy. 2. How inflation affects bonds If things are going well, and consumer spending, as well Things tend to get more expensive over the years. This as bank lending, are starting to look too strong, the Bank rise in prices is referred to as inflation. When inflation is of England could raise the interest rate to slow things high, it can be a problem for bonds because the income down, and reduce the demand for borrowing. they pay has normally been fixed at the time of issue. Normally, bond prices tend to move in the opposite A bond that offers interest of 5%, for example, may sound direction to interest rates. We can illustrate this with a good in isolation, but if inflation is running at 4.5%, the simple example. Imagine you had a choice between a real return, or return after adjusting for inflation, is only savings account that pays interest of 0.5% and a bond 0.5%. This means bonds tend to become less attractive that offers you interest of 1.25%. In choosing where to (and prices fall) when inflation is rising. invest your money, you’d have to take into account the higher level of interest paid by the bond and decide On the other hand, if inflation is falling, a fixed interest of whether it is worth the greater level of risk it involves. 5% becomes a lot more appealing. Therefore, in a situation We’ll look at this risk in more detail on pages 8 and 10. where inflation is falling or low, bond prices tend to rise. 5