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There is a financial market out there called the bond market which is worth over £100 trillion (yes, you read that right…well over £100 trillion).
Most of the time it barely gets a mention in the newspapers or on the television news.
Yet what happens within this global market has a crucial bearing on your mortgage payments, the value of our currency, the health of your pension fund and the interest rate you get on your savings.
Quietly, in the background, this market has been doing some worrying things in recent years. While it used to be seen as a relatively safe and non-volatile market to be in, it is now increasingly shunned by investors as it has been offering negative returns.
Tim Price, from Price Value Partners, who spent the first couple of of decades of his working life trading in the band market, explains the issues
The financial press likes to use the phrase ‘government spending’ to describe the government’s apparent generosity, whether in terms of funding the welfare state (the likes of state pensions or the NHS) or paying for schools or the police or the armed forces.
The sad reality is that the government has no actual money of its own. The money it spends is raised from the British people in the form of taxes.
Whenever government spending can’t be fully paid for out of general taxation, it borrows the shortfall in the bond market.
A government bond, also called a Gilt (short for ‘Gilt-edged security’), is simply a loan, an I.O.U. issued by the government, typically to an institutional investor such as a pension fund.
Let’s use the example of an actual UK government bond:
There is a 5 year Gilt which carries an annual interest payment of 1.25% and which matures (i.e. the debt is repaid) in 2027.
The series of cash flows will be as follows, assuming a purchase worth £1 million.
Bonds have long been deemed the most appropriate investment for pension funds in that they have fixed liabilities in the future (i.e. pension payments to pension scheme members) for which government bonds are regarded as the most appropriate way of matching those liabilities.
It’s crucial to appreciate one thing above all about bonds:
To explain this, think about that five year Gilt again.
Bond prices don’t just respond to changes in interest rates, they also respond to changes in inflation.
This is intuitively obvious:
Most western governments have a budget shortfall which can only be funded through the issuance of government debt through the bond market.
How bad has the international bond market been this year?
The US, unsurprisingly, has the biggest bond market in the world. According to Edward McQuarrie, emeritus professor of business at Santa Clara University and an active miner of historical investment data, this year’s bond returns are the worst since 1842.
That translates to losses for bond investors running into hundreds of billions, if not trillions.
Bond prices move inversely to interest rates – the higher interest rates go, the worse the damage for bondholders.
That inflation is spiking higher is also bad news.
Higher interest rates will translate to higher mortgage rates for borrowers on variable rate mortgages, so it’s quite plausible that property prices will fall even as it gets more expensive for existing mortgage holders to repay their home loans.
The outlook for savers is more positive, of course, but cash deposit rates are still likely to remain some way below the official inflation rate.
It’s time to look at what is in your pension fund, if you haven’t done so for a while.
Tim Price is co-manager of the VT Price Value Portfolio and author of ‘Investing through the Looking Glass: a rational guide to irrational financial markets’.
This is not financial or investment advice. Remember to do your own research and speak to a professional advisor before parting with any money.