How likely is the bond market to crash and ruins us all?

When countries go into debt, they don’ reach for the credit card. They reach for bonds. By selling bonds, a country gets a stack of cash it can spend, and all it has to do is pay back those bonds in the future.

A lot of countries have a lot of debt, the global bond market is active. People don’t just hang onto the bonds they bought from governments. They’re traded. The price of the bit of paper goes up and down even though the amount it entitles you to stays the same.

Wikipedia explains the idea neatly:

Treasury notes (or T-notes) mature in two to ten years, have a coupon payment every six months, and have denominations of $1,000. In the basic transaction, one buys a $1,000 T-Note for $950, collects interest of 3% per year over 10 years, which comes to $30 yearly, and at the end of the 10 years cashes it in for $1000. So, $950 over the course of 10 years becomes $1300.”

Some people find bonds to be a very good investment and they are also closely watched as markers of trouble. When it looked like Greece was going to be kicked out of the eurozone, its bond yields shot through the roof. (Bond yields are the inverse of the market price. If you pay $1000 for the bond described above, your yield is zero (assuming inflation of 3 per cent).) In 2011, everyone was selling Greek bonds and buyers were few.

Screen Shot 2015-02-13 at 10.53.54 am
In late 2011 if you bought a Greek government bond you were brave or crazy. Its yield was 40 per cent, implying people were worried the government would not honour it. Source: Trading Economics

Those high yields said nobody wanted to buy Greek bonds. Or Portuguese, or Italian. Screen Shot 2015-02-13 at 10.57.20 am Screen Shot 2015-02-13 at 10.56.49 am

Bonds work a bit like a stock. There’s always something to worry about.

When yields are up and price is down, it’s because people think that entity is going to go broke. When yields are down and prices are up, people start to worry that the price has overshot and might suffer a damaging correction.

Overall, riskier countries have lower bond prices and higher yields. For example, Japan’s bonds cost a lot, and yield just 0.4 per cent, because that nation is believed to be trustworthy and reputable.

But suddenly, the whole bond market is looking more Japanese, and that should rouse suspicion.

Bonds are a hot topic because of plunging yields in the last few years.

Screen Shot 2015-02-13 at 11.05.01 am Screen Shot 2015-02-13 at 11.03.59 am Screen Shot 2015-02-13 at 11.03.22 am

Does anybody really believe all the risk has gone out of these countries? Does it really make sense that Spain can borrow money at under 2 per cent? I think I’m less of a credit risk than Spain (unemployment 24 per cent) and my credit card company charges 10.99%.

What we may be looking at here is a bubble. All these bonds are in hot demand. But what happens if the bubble pops? The people that hold them lose money. That includes central banks, hedge funds, private investors, superannuation funds and banks. Any of whom could upset financial stability.

The reason this topic is hot is that a sharp object has come over the horizon that could burst the bubble. A rise in US official interest rates.

It seems likely that the US will start raising interest rates in the next few months, given their strong recent economic performance. (This is the view of the RBA Governor, at least). If outlooks for the US economy and global economy are better, a rate rise could coincide with investors deciding they’ve had enough of boring safe bonds, and getting back into stocks. That would see bonds being sold off.

The Governor of the Reserve Bank is expecting such an event, he has just revealed in testimony this morning to the House of Representative Economics Committee.

The size of the global bond market is big enough that a sharp crash would hurt the financial system. And we’ve all learned that crashes in the financial system hurt the real economy soon enough.

Further reading:

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Thomas the Think Engine is the blog of a trained economist. It comes to you from Melbourne Australia.

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