Quantative Easing

Posted on 17 October 2011 by Douglas Chadwick

I have been asked my opinion on the effect of Quantitive Easing (Q.E.) on Gilts and Corporate Bonds. Well I am not a financial expert in any shape or form,but this is my understanding of Gilts and Bonds and the possible relationship with Q.E. The Bank of England (B.O.E.) prints new money and releases this into the economy. This results in a devaluation of Sterling. The purchasing power of the pound has fallen by more than 80% in the last fifty years. Some of this is down to outright political manipulation and incompetence,some to non competitive manufacturing and some to Q.E. be it obvious or by the back door.
 
Anyway to the question of what happens to the price of Government and Corporate Bonds at a time of Q.E. Well the recent evidence from the last bout of money printing was that the Bond values went up. Our Banks received this money at almost zero interest rates and then instead of lending it back to industry they ploughed it back into Bonds with returns many times greater than the B.O.E. rate. This resulted in the Banks making heaps of profit and the start of the repair to their own balance sheets. The Gilt and Bond sectors were a great place for the private investor to have their own money invested at this time.
 
This seems to make sense to me. A Bond is issued for a fixed term with an annual interest rate based on the start price. The price of the Bond can flex up and down according to demand. Only a certain amount are issued so if demand is greater than supply you would expect the prices to go up. After all that is what happens in the real world. So Q.E. in the hands of the Banks put the demand in place and up went the Bond prices. That put smiles on the faces of the Bond fund sector managers and their investors.
 
There is a downside to the increase in Bond prices and that is the rate of interest (the yield) will come down for those people paying the higher prices. The interest is a fixed amount based on the starting price of the Bond. So double the price of the Bond and you halve the yield. Now it is my understanding that Income Fund managers rely to some extent on the yields from the Bonds they purchase. So these gentlemen cannot be happy bunnies at the announcement of Q.E. Also you must remember that at the end  of the term the Bond is redeemed at the original issue price. So if purchased above or below this price then there is a loss or a gain to be absorbed. But this is a simple arithmetic calculation at the time of purchase.
 
Lower yields from the gilt and bond market should lead towards longer term lower interest rates in general. Which in turn should in theory stimulate borrowing which again in theory should stimulate the economy. If this happens then stock market equity values should be driven upwards. But the big question is does Business and Industry have the appetite for expansion at this time. Do they trust politicians and the finance industry. I am damned sure I dont. So I guess we wont know what happens until it happens. So it is just a question of watching the numbers and looking for the trend.