6.5The behaviour of security prices

In this section, we summarise what we have said about the theory of asset pricing as

it applies to bonds and to company shares. We then look at how the sorts of events

that are regularly reported in the media as causing bond and share prices to rise and

fall can be tted into this theoretical framework. We also take a critical look at the

theory and consider whether there might be other forces at work.

According to the theory we have developed in this chapter, security prices change

largely as a result of shifts in demand. (Remember that in the short term, supply is

xed.) The demand for securities shifts as people change their view of the value of

the income stream which the securities promise to deliver.

Consider bonds rst. If we assume that the risk associated with any particular bond

is xed, the major source of changes in valuation is changes in interest rates. The

value of the income stream from a bond (with xed coupons remember) falls when

interest rates rise because better rates can be earned elsewhere. Its value rises when

interest rates fall and the alternatives are less attractive. We also noted in the last

section that people would try to prot from a capital gain (and avoid a capital loss)

by anticipatinginterest rate changes. Thus any event which might contain informa-

tion about the next likely change in interest rates will be seized upon. Investors will

buy (or sell) and bond prices will change, regardless of whether interest rates do in

fact change. With most government bonds, it is generally safe to assume a constant

(and low) level of risk, although there have been cases where governments have

had to suspend payment of interest and/or apply for the rescheduling of repayment

of principal.

Corporate bonds, however, may easily become more or less risky, depending upon

the trading performance of the rms which issued them. This creates the opportunity

for credit rating agencies to exploit economies of scale and specialist expertise in

order to provide assessments of risk. This service is purchased by issuers of bonds

who nd that a reputable credit rating enables them to borrow on better terms than

would be the case if investors had no guidance. The best known agencies are Moody’s,

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6.5 The behaviour of security prices

Standard and Poor’s, and Fitch (all based in the US), and IBCA, a UK-based organisa-

tion which merged with the French rm, Euronotation, in 1992. Box 6.6 shows the

basic categories used by Standard and Poor’s (S&P). These are sometimes modied

by () and (–) to produce a ner series of categories. Bonds rated from AAA to BBB

(inclusive) on the S&P scale are sometimes referred to as ‘investment grade’ bonds

since it is only these bonds that professional investment managers are normally

prepared to hold. But it is only when we get down to grade D that we are dealing

with bonds which are either in default or are likely to be in default. It follows from

this that the difference in yield required by the market as we move from one grade

to another looks comparatively small, usually less than 30 basis points.

Box 6.6

Standard and Poor’s bond credit ratings

Investment	grade	Speculative	grade
AAA		BB
AA		B
A		CCC
BBB		CC
		C
		C1
		D

What events might indicate future changes in interest rates? In Chapter 3 we saw

that the immediate cause of changes in the short-term nominal interest rate were the

decisions made by the central bank. For this reason, therefore, anticipating interest

changes usually involves studying government priorities and guessing what the bank’s

likely response will be. Since policy changes over time, what might be a good indicator

on one occasion may be less effective years later. In the early 1980s, for example, the

UK government paid great attention to a monetary growth rule. Annual targets were

set for the rate of expansion of the money stock. Thus, whenever actual growth in

the money supply showed signs of breaching the target (as it often did), bond holders

would sell in order to avoid the capital loss that they expected to occur when the

Bank of England raised interest rates. The selling, of course, meant that bond prices

didfall. Monetary targets were abandoned in 1985 and in the later 1980s monetary

policy followed an exchange rate target. In this period, therefore, bond prices became

very sensitive to movements in the exchange rate, falling when the exchange rate

fell and vice versa. Since 1992, the target has been the rate of ination itself. In these

circumstances, bond prices are sensitive to any news which suggests a change in

the rate of ination which may itself lead the Bank of England to change interest

rates. To make it easier for everyone, nancial markets included, to anticipate the

Bank’s response (to understand its ‘reaction function’ in the jargon), the Bank now

publishes a great deal of information which shows how its decisions are reached. The

main sources of this information are the quarterly Ination Reportand the minutes

of the monthly meeting of the Monetary Policy Committee.

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Chapter 6 • The capital markets

Thus, while we can say that bond prices will change in response to changes in risk

(for corporate bonds) and interest rates (all bonds), it is difcult to say what actual

events will affect bond prices at all times and in all places. Nonetheless, Box 6.7

shows some events typical of those which inuence bond prices.

Box 6.7

Inuences on bond prices

Risk	The state of the economic cycle (corporates) Firm-specic events (corporates)
	State of government nances (gilts)

	Ination
	Monetary growth
Interest rates	Exchange rate
	Government borrowing
	Overseas interest rates

Box 6.8 contains a report from the Financial Timesof 18 May 2006 commenting

on the general rise in bond yields in the previous few days. It illustrates a number

of points which we have made about the bond market in this chapter. Firstly, and

most obviously, since the headline refers to a rise in yields, and we know that prices

and yields move inversely, we must expect the report to be talking also about a

fall in prices. It does this in the third sentence by saying that the UK gilt market was

‘hit’ (code for an unexpected event which caused prices to fall). The unexpected

event turns out to be evidence that inationary pressures might be greater than

markets had thought and therefore that central banks might start raising interest

rates. In the UK, the evidence for this appears to be the fact that a member of the

Monetary Policy Committee voted in favour of an interest rate rise at the last meet-

ing (when previously all members had voted for a ‘hold’ or ‘cut’). In the eurozone,

the evidence came in the form of data which showed core consumer price ination

rising. Notice that the growing fear of an interest rate rise requires market agents to

take a view about central bank policy objectives (low ination) and the instruments

at its disposal for achieving them (interest rates).

Turning now to equities, Figure 6.4 tells us that equity prices will respond to

any event which causes a change in the required rate of return or in the level of

prots and prospective prot growth that contribute to that return. Compared with

government bonds, the range of inuences is certainly wider. Government bond

prices are generally affected only by economy-wide or ‘whole-market’ events, which

foreshadow interest rate changes, and when such events occur, bond prices move

pretty much as a whole together. With corporate bonds there is the possibility of

rm-specic events affecting some bonds and not others.

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