6.3 Bonds: supply, demand and price

volatile. In addition to their secure returns, bonds are also extremely marketable.

Approximately 60 per cent of London Stock Exchange transactions, measured by

value, are in government bonds.

For some investors, the tax treatment of government bonds may also be an attraction.

No capital gains tax is payable on government bonds provided that their holders are

deemed to be holding them as an investment and not to be actively trading in them

for prot. (Banks and building societies are so regarded, incidentally, and their capital

gains on gilts are taxed as prot.) Remember that ‘low-coupon’ bonds will be trading

at a discount to their redemption value. Thus a large part of their redemption yield

is made up of the eventual capital gain to be made at maturity. This gain we have

seen is not taxable while the coupon payments themselves are taxed at the investor’s

marginal rate of income tax. Such bonds are obviously attractive to investors who

expect their capital gains to exceed the current tax-free threshold and in particular to

those who also pay income tax at above the minimum rate. This tax treatment creates

a rather specialised demand for low-coupon stocks. This raises their price relative to

other stocks and explains why their (pre-tax) redemption yields appear to be out of

line with (i.e. below) those on higher-coupon stocks.

Granted the attraction of xed-interest bonds is the secure income that they

yield, we know that their price uctuates with changes in interest rates. This gives

rise inevitably to capital gains and losses on bonds not held to redemption and this

encourages a certain amount of trading for capital gain, particularly when, as in the

1970s and 1980s, nominal interest rates were volatile.

In Figure 6.3 we have drawn the supply curve for bonds vertically at S. The demand

curve slopes downwards, suggesting that, other things being equal, holders of bonds

will be willing to hold more at lower prices (and higher yields) than at higher prices

(and lower yields). The equilibrium price is at Pand yields are at some correspond-

ing, given, level. What is likely to cause the demand curve to shift? Taking long-term

inuences, rst of all, we should expect the demand curve to shift outwards with

increasing income and wealth. Other things being equal, we should expect people

and rms to wish to maintain the current balance of their portfolios. If portfolios are

Figure 6.3
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Chapter 6 • The capital markets

growing, then the demand for bonds will expand in proportion. Notice that this

means that in the long term the supply curve can also shift to the right without

necessarily inducing any rise in yields (fall in prices). Governments have sometimes

worried about the interest rate consequences of nancing the PSNCR by bond sales

which continually add to the stock of bonds. These worries obviously overlook this

elementary point that the demand curve is also shifting to the right.

As we have seen, the price that people are prepared to pay for bonds is equivalent

to the value that they place upon the income stream that it gives them. For a given

coupon and redemption value, eqn 6.7 tells us that this value in turn depends upon

the rate of interest at which the coupons and redemption values are discounted. As

always, the rate at which we discount is the rate of return that we require from the

asset, and this is the rate that we could get on comparable alternative assets. In short,

therefore, the price of bonds will vary inversely with interest rates. In our diagrams,

the demand curve moves outwards when interest rates fall, and vice versa.

Clearly, if the price of bonds uctuates in response to interest rates, investors

who intend to sell before redemption can make a capital gain or a capital loss. For

example, someone holding fteen-year bonds for a ve-year period will nd that she

has made a loss if long-term interest rates fall over the ve-year period. Someone who

buys two-year bonds, intending to hold them for six months, will make a capital gain

if short-term interest rates fall. The way to make these capital gains (avoid losses) is

to buy (sell) just before interest rates change. This, in turn, means buying (selling)

whenever an interest rate change is expected. If this is true, notice that it is not actual

interest rate changes that cause a change in price but only expectationsof an interest

rate change. This explains why bond prices often rise and fall, even when interest

rates do not actually change. It also explains why certain events seem to be regularly

linked to changes in bond prices. For example, if the latest gures on unemployment

or wage settlements suggest that the rate of ination might be about to increase, bond

prices will fall if the market jumps to the conclusion that these signs of ination are

also signs that the central bank may be about to raise interest rates. Alternatively, a

sharp appreciation in the external value of the currency might lead markets to expect

a cut in interest rates in the near future. If so, the expectation itself will be enough

to cause bond prices to rise. We shall look at some more examples in section 6.5

where we shall see (a) how relevant events bring us always back to interest rates

and (b) how often our interpretation of relevant events involves having to make an

estimate about government thinking and policy.