Not All Investors in Bonds have Lost Money

While some countries such as Greece have been terrorized by the bond markets, the governments of other countries have seen the interest rates on their debts fall to record lows.  So while some bond investors have been losing money in Europe, there have been others who have raked in good returns.

There can be considered to be a large pool of money which moves around the global financial markets looking for the highest returns.  This pool of money is made up of pension funds, cash from wealthy individuals, as well as sovereign funds run by various countries.  The money typically follows a predictable pattern over the business cycle – to shares and other risky investments when times are good and to bonds and other safer investments during a downturn. 

This time around, the severity of the recession has heightened the sense of fear in the market and investors have become picker about where they park their money during the slump.  This coupled with the high level of debt that many governments (and companies) took on-board during the boom time has resulted in the sovereign bond market being split into winner and losers.  The previous post dealt with the losers. But if money is to be invested in bonds during the recession and some governments and many firms (considering all of the bankruptcies) are out of bounds, it has to go somewhere and it goes to the winners.  

And the winners have been the governments of the US and the UK among others.  The interest rates on 10-year government bonds for both countries have fallen below 2.0% to record lows.  Along with investors seeking safety, the reduction in interest rates has also been driven by the central banks buying large quantities of government debt as part of their efforts to lift the respective economies out of their slump. 

But the thing that investors are asking now is whether bonds will remain popular.  When the global economy starts to pick up again, investors will be willing to take more risks.  And the buying by the central banks is near an end.  The Federal Reserve in the US has not suggested that it will again buy more bonds issued by the US government even though the Bank of England has committed itself to buying more UK government debt.  Furthermore, not many investors will be happy with a return of 2.0% in comparison to recent strong gains made in the share market.  Rallies in both the share market and the bond market is a contradiction that cannot continue for too long and either the optimist buying shares or the pessimists sticking with their bonds will be proven wrong.

However, despite some signs of better prospects for the global economy, there are some who still think that interest rates for these bonds have further to fall.  If the economic recovery is weak, the factors that have been driving the rally will continue.  Then, a return of 2.0% and more gains in bond prices (interest rates and bond prices move in opposite directions – see the previous posting) may be a clever bet if things turn out for the worst.  This is where those bankers are supposed to (but don’t always) earn their exorbitant pay packets. 

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.

Another Bailout for Greece but More Likely to Follow

Greece was bailed out again last week, and despite a lot of people losing a lot of money, Greece will probably need further funds down the line.  Let’s have a look at why this is likely to be the case (despite what politicians in Europe would have you believe).

First, why a second bailout and why now?  Discussions with the Greek government about how to deal with its high level of debt had been dragging on.  Politicians in Greece were understandably keen to reduce the burden on its citizens who had to suffer amid the slump in the domestic economy.  However, the proponents of the bailout, the European Union (EU), the European Central Bank (ECB), and the International Monetary Fund (IMF), wanted to impose requirements for the Greek government to slash government spending to deal with the mountain of debt despite the pain this would cause.  The negotiations could have continued except for that Greece had to repay 14.5 billion euros worth of debt in March but didn’t have the funds. 

The bailout itself is to deal with the sheer size of the debt taken out by the Greek government.  The outstanding amount of Greek debt was around 165% of the GDP of Greece in 2011.  It is not only the scale of the bonds but also the lack of growth in the Greek economy.  This is important for paying back the debt as a larger economy will result in higher tax revenue for the government to reduce the debt.  However, the Greek economy shrank around 6.0% in 2011 and is expected to be 3.0% smaller in 2012 with growth forecast to return only in 2014.  The economy in Greece may struggle to even achieve these dismal estimates as the cuts to government spending could create a vicious cycle where cuts to spending weaken the economy and result in lower tax revenues which, in turn, increase the size of the necessary spending reductions. 

The rescue plan for Greece is expected to cost 130 billion euros with private bond holders “voluntarily” accepting a 53.5% reduction in the value of the bonds.  The actual losses for investors in Greek debt is more than this as the deal also involved a reduction in the interest rates on the Greek debt.   The lower rates mean that investors will be getting less money than they thought and the value of the debt will in fact be reduced by 75%. 

Despite all this, the aim of the bailout is merely to reduce the amount of Greek debt to 120% of GDP by 2020.  That is the same relative level as Italy is at now and is a relative amount of debt which is still seen as problematic.  So the bailout is not going to solve the problem of high debt.  And these plans rely on growth predictions and assumptions about privatization in Greece that many believe are “optimistic” to put it politely.  But, everyone from politicians in Greece and Europe and investors were adamant in avoiding a messy default where holders of Greek debt could lose even more and the market for government debt in Europe would have been thrown into disarray.   

So, this all points to the likelihood that Greece won’t be leaving the front pages of our newspapers any time soon.