“As always, the performance of an investment depends on the price one pays for the asset, the price one achieves when selling the asset and the income received in between,” says Kevin Telfer, fixed income product specialist at Kames Capital.
If an investor in a portfolio of bonds intends to hold them to maturity, the long-term driver of performance will be the interest rate and maturity payments received and any defaults incurred.
So when governments reduce interest rates it makes bond coupons more attractive, driving up demand and leading to an increase in the capital value, explains Neil Mayfield, principal at Mayfield Investment Management.
Active fund managers rarely hold fixed income assets to maturity. Instead, they actively trade bonds and loans, seeking to purchase undervalued investments and sell them when their valuations improve – like all active investment strategies.
A bond’s reported market value reflects the market’s perceived attractiveness of the interest and maturity payments, and the perceived risk of the borrower defaulting.
Other factors that make a fixed coupon more attractive include deflation, economic uncertainty and market shocks (‘black swans’), which create fear and drive investors to seek safe havens in bonds from major economies.
“Greed leads investors to seek high yield from bonds with more risk thereby increasing prices,” he says.
One of the chief functions of credit ratings agencies is to guide investors as to the financial security or otherwise of an issuer.
A higher rating might make a particular government or corporate issuer more attractive, thus lowering the coupon they need to offer on new issues to attract buyers but raising the price and reducing the yield of existing issues.
Of course, supply and demand also play a factor, as Mr Telfer explains: “Like all investments, if supply increases, prices tend to fall and if demand increases, prices tend to rise.
“The impact of this can be quite significant. For example, the Bank of England’s QE programme has materially reduced the supply of UK government bonds available to other investors, driving prices up.”
Mr Mayfield also suggests legislation can be a driver for fixed income as “it may require particular classes of investors to invest in fixed income – for example many UK pension schemes are obliged to hold long dated gilts to offset their obligations to pay pensions to members.
“This requirement increases demand and pushes up prices.”