Bonding for the next crisis

So far,so boring. It gets only mildly more interesting to note the following. First,if you are a bond holder,inflation is bad for you. Getting Rs 100 back after 10 years of high inflation means that money will buy you much less.

Second,bond holders keep an eye on interest rates. If rates rise,new issues of Rs 100/10-year government bonds will offer a higher coupon rate. Then existing bonds offering 5 per cent will become less attractive. If bonds are traded,as they are in the bond market,the market value,that is,the price,of older bonds will fall. They will be deemed to be worth less than Rs 100. The yield of the older bond in the market will then be the rate at which the same periodic return Rs 5 can be obtained from a bond valued at less than Rs 100. This rate obviously will have to be higher than 5 per cent.

Therefore as interest rates rise,bond prices fall and bond yields rise. The converse happens when interest rates fall: bond prices rise and yields fall.

Equally mildly interesting are these facts. Government bonds are considered safe bets in general because governments dont generally default. So,government bonds become especially attractive when risk perception in general rises. But,and in a well-functioning bond market,not all government bonds will be judged equally.

Governments that seem better at delivering low inflation will get better reception; remember inflation hurts bond holders. Governments that do not run consistently huge deficits will be favoured as well. Big deficits are thought to stoke inflation as well as increase the risk of debt default.

Now for the more interesting bit. Recall that 2008s financial crisis and the subsequent economic downturn have led to Western governments bailing out the financial system and spending extra to boost economic activity. So,thats a lot of government bonds being issued. Since this has come at a time stocks and other financial instruments look really risky,bonds have acquired an extra patina of safety. Therefore big demand for bonds is matching higher supply.

The bond market is brisk. And since Western governments have cut interest rates sharply to fight a downturn,bond prices have jumped and bond yields have tanked. Bond buyers are willing to invest despite falling yields,a proof of how attractive bonds have become as a safe choice. Also,Western economies are experiencing falling inflation,and thats another attraction for bond holders.

It all looks good. Private finance and major economies are in crisis. Governments are helping out by raising the cash via government bonds,which private investors are keen to buy,and therefore government financing is coming cheap.

But,and this is the really interesting bit,this is a boom that can end badly and if it does,it will not be financial firms but governments which will be ranked according to how badly they got hurt.

To see this,we must appreciate a paradox. The big jump in Western bond issue is an attempt to revive finance and economies. But if that attempt is successful,bonds will become less attractive. First,because the general risk environment will improve and so options like stocks will become more palatable. Second,business and consumer sentiment will improve and therefore demand will increase and therefore downward pressure on prices will reverse. Also,recall that big government debts,like those being racked up by bond issues now,are considered inflation generators. Prospects of reversal in the price trend will make bond holders nervous. Therefore,the bond boom is sort of safe as long as bond financing fails to achieve its goal of reversing economic bad news.

Theres another factor. Apart from the US,whose bonds are denominated in the worlds reserve currency,the dollar,and whose biggest-economy status increases bond holders safety perceptions,other Western economies may sooner or later face the classical bond market question: how much government debt is safe?

According to analysts,Britain is close to facing this question. Smaller European economies like Greece,Spain,Ireland and Italy are already being interrogated. The question is more severe typically when foreigners hold a large proportion of government bonds,as is the case with Britain and some other European countries.

Thats the case with the US,too. But foreigners,including foreign central banks,have a vested interest in not losing faith in US bonds. First because they,like everyone else,will want to avoid the global dislocation that will come from a run on US bonds. Second,because their own assets,the massive quantities of US bonds they hold,will suffer.

But still,the sheer quantum of new US debt will keep the question alive. Barack Obamas huge stumulus package has just passed. And that puts the paradox in focus: the prospect of private sector recovery may be accompanied by government sector suffering. Or,non-US Western governments may suffer on account of their debt volume. Germany anticipated this and recently said it will introduce a budget balancing rule. This will comfort holders of German bonds. But no such assurance has come from,say,Britain,which soon needs to give the bond market an exit strategy,that is,how it will pay back the bonds.

Frankly speaking,no one knows how this will play out. A relatively benign unwinding is likely but dont dismiss the opposite outcome.

Now,in early 2009 and at the height of cheaply-financed government efforts to rescue the private sector,no one wants to know about a future crisis in government finance. But remember that in early 2006,at the height of a cheaply-financed private sector global boom,no one wanted to know about a crisis in private finance.

saubhik.chakrabartiexpressindia.com