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Why you should care about the bond market chaos

What’s this ‘premium bond yield rate return’ stuff all about anyway? Here’s our (mostly) jargon-free guide.

Image: rednuht via Flickr

Updated November 2nd

YESTERDAY AFTERNOON’S news bulletins – and most of today’s newspaper pages – are dominated by the activity on the world’s bond markets which saw the price of Irish bonds skyrocket yesterday afternoon.

The only major problem with most of this coverage is that, if you’re not already au fait with the jargon and insider lingo of what’s going on, it’s difficult to discern the significance of what’s happening – other than to get a pretty strong message that there’s something not quite right.

So: here’s what’s going on, and what it means.

First of all, forget your idea of what a ‘national debt’ is. Most people have the idea that when we speak about national debt, we’re referring to money that we owe to other countries – for example, the kind of debt held by third-world countries that activists like Bono and Bob Geldof have tried to get richer nations to forgive.

For the most part, however, the world’s developed nations don’t have that kind of debt. When a developed country needs to borrow money – when, for example, it’s earning less money than it’s spending and decides to borrow money rather than cut spending – it issues bonds. A bond is, to be simple, a piece of paper sold to an investor, which guarantees them a certain interest payment (or yield) every year in return for their investment.

So, last year for example, Ireland recorded a budget deficit of €24bn – it spent €24bn more than it received in income. To plug this gap, it issued bonds to that value (and slightly more, just to be safe) through the National Treasury Management Agency.

When bonds are being issued, the government only suggests a broad guideline of the interest an investor can expect to get. If it’s issuing a 10-year bond, say, it might suggest an interest rate of 5%. The actual rate an investor will receive is determined by an auction.

If – as Ireland has had for all of this year – there are more people seeking to buy the government’s bonds than there are bonds to sell, then the interest rate is driven downward because investors are competing with each other to offer the government the best value.

So, if Irish bonds are heavily desired, the interest rates the government will have to offer are pushed downward – meaning that it will have to pay a smaller interest rate on the bonds it issues.

Conversely, then, if there’s little demand for Irish bonds, investors can ask for higher interest rates – and the government, which presumably needs the money if it’s issuing a bond in the first place, has to oblige.

Why would there be low demand? Well, that’s actually quite a simple question. Put simply, there’s no major guarantee that the government will honour its commitment to pay the interest it says it will.

The yield on Greek ten-year bonds right now is an astronomical 11.678% – mostly because investors are unwilling to invest in Greece, being fearful that the government would be unable to pay the interest, or – at the end of the ten year period – repay the full amount invested. (This, by the way, is what a ‘default’ means. If you can’t make your loan repayments, you’re defaulting on your loan. In most European cases, a bailout will come from the EU or the International Monetary Fund.)

If investors are anxious about getting their money back, they’ll demand higher interest to help cover the costs.

Thus, the level of demand for a bond will dictate the interest, or yield, the government has to offer in order to borrow more money. The less demand for bonds, the more expensive it is for the government to borrow.

And that’s really important these days: because Ireland’s government will be borrowing to balance the books for a few years to come.

So what does all of this mean? Well, if the markets – the collective wisdom of the world’s investors – think Irish debt is risky, then when the government issues its next bond auction it will have to pay a higher interest on the loans it needs to run the country.

And this, if it goes on for any reasonable length of time, is a worry. Ireland’s national debt at the end of August – almost entirely in the form of bonds – was €87.24bn.

Five years ago, the yield on 10-year bonds was about 3.08% – meaning that the annual interest bill on borrowings back then, if we were €87bn in debt (which we weren’t) would have been about €2.7bn a year. Now, with a yield of 7.2% (as it was at the time of writing) the annual interest bill would be €6.26bn.

To put that in context, the government is currently trying to finalise plans to plug a €3bn gap in this December’s budget – which will still come nowhere near balancing the books, leaving us standing at the edge of a spiralling abyss of having to borrow simply to repay the interest on earlier loans, let alone to run the country – or having to face an embarrassing default and going cap-in-hand to European and international bailout funds.

If the country’s debt burden was to become too overwhelming, the government could (we stress the ‘could part) get to the point where the country could simply be unable to afford further borrowing – meaning that spending would need to be slashed massively with the loss of many public services.

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About the author:

Gavan Reilly

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