Sunday, 11 March 2012

Bond Markets Ain’t All Bad

The bond markets have caused havoc in Europe.  A rapid surge in interest rates on the debt of some European countries have forced governments to cut back on spending at a time when economic theory would argue for governments to spend more.  The results have been carnage.  There have been riots in Greece, protests in Spain, and the toppling of numerous governments in Europe.  Many people have pointed a finger at the bond market implying some notion of culpability for this.  The bond markets have something to answer for but not for the current situation.  To understand why, we must first however look at the role of the bond market in setting interest rates on debt.

Interest rates on bonds are set by the forces of demand and supply.  A large number of buyers will increase the price of a bond which will result in a lower interest rate.  This is a concept that even I struggled to come to terms with so I will provide a theoretical example to explain why bond prices and interest rates move in opposite directions.

For example, consider a government selling a fixed number of bonds where buyers pay $100 now and receive $150 in one year which is a return of 50%.  The high return attracts other investors who buy the bonds from the original buyers at a higher price and the price increases to $120 but the amount which is paid out at the end of the one year is still $150 so the return on the bond is now $150/$120 = 25%.  The government can now sell more bonds at the lower interest rate. 

But the opposite can also occur.  If investors do not think that the government can pay back $150, the original return of 50% will be seen as too low in relation to the risk that the government will default.  That means that if the original buyers want to sell, other investors will want a higher return to compensate for the riskiness of the bond and so the price of the bond will fall.  For example, investors may only offer to buy the bonds for $75 which means the interest rate on the bond is 100% (i.e. investors will double their money).  And if the government wants to sell more bonds, it will have to pay the higher interest rate.

The changes in the interest rates in this manner are an important part of the essential role of the bond markets.  In theory, the return on any investment must be enough to reward the investor for taking the risk of investing their money.  So interest rates provide an important signal on the risk that the government or the company that has issued the debt will not be able to pay back the money.  It also acts as a warning to governments that take on too much debt (or any other action that would be seen to hamper debt repayment) that they will be punished by higher interest rates.

So the problem is not the high interest rates that some governments in Europe are currently been forced to pay but that there was no warning from the bond market prior to the crisis.  Previously, investors had been happy with the same interest rates on all bonds from countries using the euro whether it was debt from Germany or Greece.  So Greece and the other counties have no notion that they would fall out of favour so quickly once investors realised that some government may struggle to pay their debt with the economic conditions having rapidly deteriorated.

Previously, the bond markets had been feared by any government who dared to spend too much.  One advisor for Bill Clinton was famously quoted as saying that if reincarnated, he would “want to come back as the bond market. You can intimidate everybody”.  But in the lead up to the recent financial crisis, bond investors had been caught napping.  The investors would have lost money as the prices of bonds of Greece and the other plunged but it is the citizens of Greece and elsewhere who pay the heavier price.

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