When falling rates mean a bonus

The idea of falling interest rates being good news for investors can seem a little back to front, especially if you're struggling to get by on today's low rates.

One reason for the confusion is that when professional investors talk about "fixed interest" they don't usually mean things like bank term deposits.

What they mean are investments such as Government stock and corporate bonds.

One feature of those investments is that the original investor doesn't have to hold on to them for a set term. Instead, they can be bought and sold any number of times.

Like anything that can be bought and sold, the price fluctuates.

And, all else being equal, that price moves in the opposite direction to interest rates - when rates fall, the price of existing Government stock or corporate bonds goes up, and when rates rise the price goes down.

Why the connection? Because these investments are essentially just a promise to make a series of payments - regular interest payments and then a lump sum when the investment matures.

That means anyone buying a fixed-interest investment knows exactly how much they will receive, and when.

How much are those payments worth? That depends on the return you're looking for. If you want 10 per cent, you'll be willing to pay $1000 for Government stock that will pay back $1100 in a year's time (because $1100 is $1000 plus 10 per cent). If you'd be happy with 5 per cent, you'll pay $1047 (because $1100 is $1047 plus 5 per cent).

In the real world the calculations are more complicated but the idea is the same: the more an investor pays, the lower the percentage return they get.

Investors will only pay more for existing fixed-interest investments when rates in general are falling, as they have been lately.

For the fixed-interest market, bad news is good news - when economies are weak and central banks push down interest rates, that's the time when capital gains are made.

And when investors talk about a "bull market" or a "rally" in fixed interest, they mean interest rates are falling - and the price of existing investments is rising.