Bonds are bits of paper, like IOUs, which borrowers issue to raise money. In return, the borrower will pay a rate of interest, called the coupon. Bonds can be bought and sold (and resold) by investors for a price. They are usually issued for between five and 25 years. This period is called the maturity. They can be issued by private companies (corporate bonds) or by governments. Bonds issued by the UK government are called gilts.
The interest of a bond expressed as a percentage of its price is called the yield. If a company issues a bond for £100 which pays £5 interest, the yield is 5 per cent. The price of bonds is dependant on the market - what people are prepared to pay for them. This is determined by the yields.
Let's say one year a company issues a bond for £100, which pays £10 interest - a yield of 10 per cent. If the next year the company issues a £100 bond which pays £20 interest (a yield of 20 per cent) the value of last year's bond will drop. This is because no one would buy a bond that pays less interest for the same price. Last year's bond will lose half its value - so it is now worth £50 and pays £10 interest and has a yield of 20 per cent. The value of old bonds will drop until the yields are equal. So when yields go up the price of bonds goes down.
But calculating yields is not that simple. You also have to take account of the bond's maturity. If a bond was issued originally for £100 paying £5 interest but is later bought for £95 one year before it is due to be repaid then the yield on that bond is 10.5 per cent ([(5+5)/95] x 100). A yield which takes the maturity into account is called the gross yield to redemption.
The market rules
An increase in inflation could wipe out the value of a bond. So if investors expect an increase in inflation they will demand higher rates of interest and yields will rise (so the price of bonds will fall).
Conversely, deflation would increase the value of a bond. So if investors expect deflation they will be willing to accept lower rates, yields will drop and bond prices will rise.
If investors are worried that the bond issuer will default on the repayment then the price of the bonds (the amount other investors will be willing to pay for it) will drop and yields will rise.
If investors expect yields to rise (and therefore prices to fall) they will withdraw from the market to avoid capital loss. This would have a self-fulfilling effect. Fewer lenders means funds would be less available and rates would rise.
The yield curve
Normally, long-term bonds offer higher interest rates than shorter ones. This is because lenders need to be compensated for tying up their money for a longer period of time. If you were to plot this on a simple graph (yields/maturity) called a yield curve, the shape would be described as positive or upward sloping.
Sometimes, however short term bond rates can be higher than long-term ones. The yield curve would be described as negative or inverted.
There are a number of theories as to why this might happen. The simplest explanation is that investors expect short-term rates to fall (because of deflation) and are therefore looking to lend long-term. This will increase the supply of lenders and bring long-term rates down.