Interest rate risk, inflation risk and the safe haven effect

This animated tutorial looks at what drives bond markets, including interest rates, inflation and economic conditions.


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In this module we’re going to delve further into the fundamental drivers of bond price and yield movements: interest risk, inflation risk and the ‘safe haven’ effect.

Different bond types, durations, geographies and credit qualities all react differently to these drivers…

But how?

Let’s start with inflation, a spectre which keeps bond investors up at night…

If inflation is expected to rise, investors will demand a higher yield, which will force bond prices down, especially for longer-dated bonds as we discovered earlier.

This is generally true for UK government bonds as well as high and low quality corporate bonds.

However, the values of lower-quality corporate bonds tend to be more volatile and, in times of heightened market uncertainty, they can move more in line with equity markets. 

What about the role of interest rates?

Central banks in different countries, or regions in the case of the EU, administer short-term lending rates by setting the ‘base rate’ at which they will lend to banks.

Central bankers usually set the rate based on their dual roles of promoting economic growth while controlling inflation. Professional bond investors dissect every press release and hang on every word of central bankers, attempting to avoid being surprised by a sudden rate move.

Bond investors debate and disagree about the appropriate central bank rate in every country or region. The prices (and yields) in the market place represent an average of these the competing views and expectations.

Short and long-term bonds react very differently to interest rate expectations.

For example, short-term bond investors respond more to expectations about central bank rates.

On the other hand , long-term bond investors fret about how inflation will erode the purchasing power of the long stream of future cash flows that the bond represents.

In times of(higher/rising/increased) political, international or market uncertainty, investors sometimes seek ‘safe havens’ for their money. Some investors panic and pull out of equities and invest into lower risk government bonds, for example.

As a result, demand for government bonds can rise, which means their values can rise sharply, driving yields lower.

The main challenge with this is getting the timing right. Many studies have shown just how hard it is to move from bonds to equities and back at the right time. Often, by the time a move is made, it’s too late.

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