By Charles Ross, Contributor
IN OUR previous articles we
have established the very close relationship between the price of a bond and
the yield on the bond, but we have not yet looked at some of the factors that
cause the prices of bonds to move up and down. There are many such factors,
including some that are related to economic fundamentals, others that are related
to investor's perceptions and sentiment, and still others that are influenced
by the mechanics of the markets in which the securities are traded.
THE INTEREST RATE FACTOR
The most basic factor that affects bond prices is the direction in which interest rates are moving. In developed country markets such as the USA or the European Union, this will often be the most significant factor affecting bond prices. When interest rates are going up, the prices of existing bonds will fall because buyers of the bonds will demand yields on the bonds which are equivalent to the higher interest rates that are being offered on new bonds or money market type investments. Since bond prices move in an inverse relationship to yields, the prices will fall in order to offer the new buyers higher yields which are in keeping with the higher interest rates prevailing in the market.
On the other hand, if interest rates fall, then bond prices will rise. This is what has been happening in the US bond market since the beginning of this year. US interest rates have fallen to levels not seen for over 40 years and as a result, bond prices have risen considerably. Investors who bought US government bonds a year - or even six months - ago have made considerable capital gains on their investment.
ISSUER CREDIT WORTHINESS
Another major factor, which affects bond prices, is the market's perception of the relative creditworthiness of the issuer of the bond. In the case of sovereign bonds, (bonds issued by countries) this perception is heavily influenced by the economic fundamentals of the issuing country. In fact, the credit rating which is assigned to a particular country's bonds, is based primarily on an analysis of the country's economic performance and policies. Therefore, if a country's economic performance is deteriorating, investors will demand a higher return on that country's bonds to compensate for the increased risk of default that they perceive to be associated with the implied worsening of the country's creditworthiness.
Higher yields will, of course, mean a decline in the bond prices. If the economic fundamentals deteriorate sufficiently, the credit rating agencies will downgrade the country's credit rating and this will often have the effect of pushing down the prices of the bonds and raising the yields. Again, if the economy improves and sustains that improving trend over time, the reverse can take place - with credit ratings improving, yields falling and bond prices rising. The bonds of developing countries are very susceptible to considerations regarding the performance of their economies and whether the future prospects are getting better or worse. In these countries, economic policy can be quite fickle and governments are not always as forthcoming with information as they should be. The technical capacity of the policy makers is sometimes quite weak and the institutions that make and implement policy are often heavily influenced by the political arm of government. As a result of this, there can be considerable uncertainty surrounding the true state of the local economy and this uncertainty leads to increased volatility in bond prices as the international market reacts to each new snippet of information that emerges.
EMERGING MARKET CHALLENGES
Although the deck may seem to be stacked against the developing countries, it is possible to make steady progress moving up the ratings ladder and to eventually graduate out of the emerging market category altogether. South Korea did this recently, only four years after the Asian financial crisis that rocked its economy and the entire region. Right here in the Caribbean, Trinidad and Barbados are two of only four countries in the Latin American region that are rated in the investment grade category.
Emerging market bond prices are also influenced heavily by political developments, both at home and abroad. Furthermore, investors hate uncertainty and that is why even events such as elections can have a negative effect on bond prices. The significant fall in Brazilian bond prices in the run up to Sunday's (October 6) presidential elections is a classic example of the international (and local) market being scared by the prospect of a victory by the left wing candidate. International events such as the possible war on Iraq can also affect bond prices since many developing countries have weak external accounts and would be affected by the rise in oil prices, which would accompany that conflict. In fact our economies are quite vulnerable and so investors must include developments in the international economy in how they assess the risk of holding emerging market bonds and the corresponding yields that they require to compensate them for taking on that risk.
- Charles Ross is Managing Director
of Sterling Asset Management Ltd.
