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WE’RE REGULARLY REMINDED that the government’s overall plan for the economy is to ensure that Ireland gets back to the bond markets – escaping from the clutches of the EU-IMF bailout.
But given how so much of the public policy debate these days focusses on Ireland’s finances – and, specifically, where we get our money from – it can often feel like the debate is going over your head unless you understand what exactly the bond markets are.
So, to try and make you a little more comfortable with that kind of discussion, here’s our crash course to what the bond markets are.
First of all, we should define exactly why we need the money. Governments, like anybody else, need to match the money that they spend with the money that they take in.
If a government’s policies mean it doesn’t have the tax income to pay for its spending programmes, it has to plug the gap somewhere – and it does that by borrowing money.
By comparison, the Budget for 2012 outlined expected income of €39.2 billion and total spending of €64.4 billion. Obviously that €25.2 billion gap needs to be plugged – so Ireland, and any other country, does this by borrowing the difference.
Obviously if times were good we wouldn’t need to borrow at all – and this was the case for much of the last decade – but given the current state of affairs, with less people working to pay income tax and more people needing social welfare help, Ireland’s got a gap that needs filling.
So – that’s what we need to go there. Now to explain what exactly the bond markets are.
Most people have a relatively straightforward idea of what the ‘national debt’ is. People often think that if a country borrows money, it does so from other countries – bringing around the situations like the ones Bono and Bob Geldof campaign about, encouraging richer countries to forgive the debts of poorer ones.
This is only true some of the time – and it’s almost never true for First World countries any more.
When a developed country like Ireland needs to borrow money like we’ve explained above, it doesn’t go to a bank or to another country – it instead sells bonds.
A bond, to put it in layman’s terms, is an IOU: a piece of paper sold to an investor, which guarantees them a fixed payment every year until its repaid. “I, Ireland, agree to repay your €10,000 in ten years’ time – and to pay you 5% interest every year until then.”
It’s not just countries that do it. Large corporations and banks do it too – and even Manchester United issues bonds occasionally, as it did in 2010, to keep the show on the road.
The fixed annual payment – basically, the interest rate that Ireland pays in exchange for selling the bond – is called the yield. (That’s what is meant when you hear someone say, ‘The yields on Irish bonds are really high at the moment.’)
This yield is fixed and agreed at the time the bond is issued, through an auction system where investors tell Ireland how much they’re willing to lend, and how much interest they want as a result.
Once the bids are in, Ireland (or, more specifically, the National Treasury Management Agency which does all of this stuff on Ireland’s behalf) then decides which ones it likes best – naturally, the ones demanding the lowest interest rate – and agrees to sell bonds to those people.
This is where supply and demand comes into play – if there is higher demand for the auction, the chances are that investors will have to offer a lower interest rate in order to get the bond at all.
But remember why investors are lending to us in the first place. They’re doing it as an investment: a way of keeping their money safe, while turning a profit at the same time. So they’re going to want a decent interest rate.
But there’s also a second purpose to the interest rate. Fundamentally, the reason an interest rate is being paid is to reward the investor, who could have put their money elsewhere – and to make sure that they get some return on their investment.
So there’s a problem if a country looks like it’s about to go belly-up. A country whose financial future is unsound – and which may not have the money to repay an investor when their bond is due to be repaid – is going to be asked to pay a higher rate.
That’s because an investor is thinking this: “If I’m lending Ireland €10,000, and I’m worried I’m not going to get it back, I’m going to make damn sure I get a decent pay-off in the meantime.”
Eventually, if people have a totally negative opinion of a country and its ability to repay its debts, the interest rate they’ll demand becomes too high – and reaches a level the country simply can’t afford.
That level varies from country to country. Most people believe that 6% is too high for a European country to pay for a 10-year bond. Thankfully, there’s a thriving second-hand market where bonds change hands on a minute-by-minute basis, allowing countries to see how much it would pay in theory if it was holding an auction that day.
In Ireland’s case, we stopped issuing bonds when the yield on the second-hand market got to 6%, and lived off our savings until the yield got to 9% and we went for a bailout.
At the time our bailout was confirmed, Germany – which is usually seen as the benchmark by which other countries compare themselves – would have paid 2.5%.
If you’re frozen out of the markets like that, your options at that point are stark and simple. You can either…
A default might seem like an easy and obvious solution – but remember that the whole point of this exercise is to keep a low interest rate, so that you can borrow more cheaply.
A country with a history of default will find it more difficult to find someone to lend to them again – and will see higher interest rates as a result.
Argentina did it in 2001 – writing off $132 billion of debt – and is still paying the price. It held an auction to sell some seven-year bonds (that is, loans which were due to be repaid in seven years’ time) last November, and paid 9% interest.
If and when Ireland gets back to the bond markets, if we were charged 9% for a seven-year bond, we’d be heading straight back to the Troika.
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Very well explained Gavan. We seem to be on the right road. You explain very well why defaulting would have been a crazy thing to do without a doubt.
Well explained Gavan. First time I have seen it explained in basic everyday language.
Unlike the gov’, if I was spending more than I took in, I’d spend less, I would never borrow. I’d be only fooling myself.nIf I don’t have the money for something, then I can’t afford it, end-of
So you never got a bank loan to buy a car? You don’t or will never have a mortgage?
Yes we should be living within our means but we will always, at some stage, need to borrow.
Kieran, the finances of a country, an entire economy are totally different to those of a household like yours.
For a start, we grow old & our income reduces & eventually die. We must therefore aim to repay our borrowings. Countries do not die and their income grows continuously. (Big difference & there are others too.)
What this means in practice is that countries rarely repay loans, or have any need to. They are simply rolled over – the ‘cost’ is basically just the interest. (Bonds are also traded in secondary markets too – the original buyer has no need to wait out the ‘term’ of the bond.)
Unfortunately, this is (unusually) a very poor article from the Journal. It might be “…everything (some people) wanted (or want!) you to know…” but it is very far from saying what we all ‘should’ know.
The arrangements for sovereign borrowing in the Eurozone are deeply flawed & place Eurozone countries at a considerable disadvantage from countries who have, & issue, their own currency.
The latter, like the UK, US, Japan & most others, are not subject to interest rate gouging by bond buyers (typically banks & other private financial sector players) during downturns in the economic cycle (whether mild or deep enough to be called a recession).
In fact, the opposite occurs. Sovereign currency countries can & do force lower lower interest rates in a downturn as a result of the usual ‘monetary policy’ choice to lower ‘base’ interest rates to make general borrowing in the economy (incl. domestic loans, mortgage rates etc.) cheaper, thus helping an economy to recover back to growth.
It means that these countries can carry. sustainably. much higher debt to GDP ratios & have considerablly more scope to apply temporary spending increases or tax cuts as a ‘stimulus’ & avoid the unnecessary business bankruptcies & high unemployment that EZ countries are suffering (& getting worse, not better).
For example, Japan has carried very high borrowing for a decade or more, now over 200% of GDP. Their interest rate is less than 1% & throughout the global crisis their unemployment hasn’t risen above 5%.
So why is it that the Eurozone, with borrowing rates for many countries are 4, 5 & 6% ?? IE 4, 5 & 6 TIMES the cost to their government/citizens compared to US, UK, Japan etc (who all have much higher debt/GDP ratios ??
You, might also wonder, why, in the face of the Euro’s 5 years of worsening crisis, austerity & all the rest, the silence is deafening on this bond market rip off, by ‘authorities’, media & (mainstream) economists alike.
Why do I say it’s a rip off?
Think about it for a moment. What the ‘markets’ are saying in demanding high & expensive interest rates is that as EZ countries don’t issue their own currency (& hence can never go ‘bankrupt’ or voluntarily default), they are adding in a ‘default risk’ premium. But, surely the Eurozone, as we are repeatedly told, was set up as a permanent entity. No ‘defaults’ or exits were considered possible. No provisions or procedures were either contemplated or included in it’s setting up. the notion was (& still is, we are repeatedly told) inconceivable. Moreover, the EZ as a whole, ultimately +does+ have a currency issuing authority which, in extremis, can fully back the currency (as it already has, notably much more in favour of banks, not countries).
So why is the system of banks & other bond buyers being allowed to charge several times the cost to, ultimately, us citizens (compared with US, UK, Japan etc.)? And at the same time hampering & constraing the fiscal policy that could have saved millions of jobs & already begun the recovery to growth & prosperity?
Who gains from this deeply flawed structure? The banks & other financial sector elites of course. The very people who foisted the design of the Eurozone on ignorant or ‘captured’ politicians, economists & media in the first place. The very same banks etc. who our ‘authorities’ have insisted we bail out for all their reckless (private sector) borrowing.
Along with the other aspects of this deeply flawed currency system, we should all know about be discussing these aspects of ‘bonds’ & demanding to know why politicians, mainstream media & economists are all colluding in this ongoing giant rip off of ordinary citizens in favour of banking elites who created this whole mess.
“Countries don’t go bankrupt.” Walter Wriston CEO Citibank (1976)nThe marketing slogan endorsed by a generation of profligate politicans.
Great comment Mike.
The craziest thing about all of this is why the government did not save money during the boom years. The bonanza giveaway budgets of the Fianna Fail years always stunned me. It was as if they had forgotten that this country had always struggled financially. Why did it never occur to anyone that this might not last forever?
Because politicians in Ireland see their primary role as getting re-elected, running the country is secondary.
not trying to defend any previous government but thats what the national pension reserve fund was
Large amounts of money were put into the Pension Reserve Fund in addition to reducing our National Debt…
But defaulting on Anglo s bonds would have been the correct move. Not defaulting on sovereign debt.
Well I think the problem was that it appeared cheaper to protect Anglo rather than allow it to go violently which would have had impact on the bigger banks. It would have resulted in having to pay more to save AIB and BoI. Anglo lied and cooked the books though, so we ended up in a fairy poor position anyway. Someone must be held accountable but burning ourselves just to say we burnt bond holders seems a little crazy.
If our govt had a pair they would have burned the bondholders long ago, the country would have suffered pain for a short term, and we would now just be returning to growth, just like Iceland.
lots of people disagree with you chucky, they’re wrong :-P
The people who would have born the brunt of the pain would have been the marginalized and the poor.
IMO, they are taking enough pain as it is.
In any case, it looks like the Governments’ strategy of honouring the bank debts will pay off.
Burnt what bond holders? Bond holders in the banks should have been burnt but not those who lent to the State….
Junior bondholder were burnt.
A condition of our program was that we honoured the senior bonds of the banks we nationalized.
Therefore, not honouring them wasn’t an option.
Ya default would have been risky as we had such a gap between income and expenditure. The bailout has allowed the country to gradually adjust itself. I wonder how much of a gap Argentina and Iceland had to bridge?
Very well explained Gavin.
Thanks for this Gavan – was getting blue in the face explaining to friends why a default or burning the bondholders was daft. I likened it to putting your savings in a bank, then them refusing to give your money back. Would anyone trust that bank again ? like hell they would!
Great article
People also need to understand that buying bonds is generally seen as the lowest risk form of investment.
This endless talk of gamblers getting their money back from the bookies is a load of rubbish.
The gov did put money aside. One good thing Charlie McCreevy did, as said above was to set up the pension reserve fund. It was going to provide pensions for retired public and civil servants. It has been nearly emptied now to rescue the banks.
The bond holders are a variety of groups such as investment funds. Some of these would be investing your private pension in these bonds in order to gain a return while ensuring that the investment was relatively safe. You see many of these investment funds advertising in the papers, perhaps after the lump sums of retired people. Credit unions may also have bought these bonds. So while it may have been great to burn the Anglo bondholders there was always the possibility of a local credit union going bust or your company’s pension fund going down the river. The affect of not burning the bondholders is that our potential bond yields are coming down all the time, with the possibility that the country will be seen as a safe bet to lend to again.
Who are the sellers of bonds?
NTMA does it on behalf of Ireland. n
Gavin covering economics 101.
Wow, this comment thread is actually much less anti-everything than I thought it would be. Good article Gavan
This article explains “bonds” in theory. However when it comes to applying it to the situation in Ireland people should not see it so simply. It does not explain the situation the country is in at the moment because of the corruption of financial institutions. Maybe you could do a similar “lay mans terms” to explain how banks got triple A ratings practically overnight. These ratings are given based on how successful the bank is. The thing is most of the ratings given were complete bs as money was moved around like a game of musical chairs. It should also explain how our banks lent money out that they did not actually have thus creating a false economy with in turn drove up property prices to extra ordinary levels. This in turn put ordinary mortgage holders and property developers into serious trouble when things went belly up having now to pay back huge sums for properties worth feck all. The bond holders who ever they are were not innocent in all this. The amount of insider trading and the corruption at the highest levels e.g Morgan Stanley & Co. meant that this worldwide pyramid scheme was either going to keep going as the music never stopped or and as did happen, there would be many winners during the good times buying and selling at a profit every year and heavy losers who did not manage to get out before in all came crashing down. Screw the bond holders, they gambled and won. Do not feel sorry for them, they just got away with murder.
Why did all the economic experts like Paul Krugman, David Mcwilliams and Constantin Gurdgiev all recommend defaulting if it was so obviously risky to do so..?
Therefore I believe the bondholders in anglo are not the same bondholders that loan money to this state?
Can someone please clarify this for all the people here????
and if we could have an article on secured and non secured debt and bond holders that would be great..
I appreciate the article but we need the full story please and not just a pro bailout, don’t ever default ever under any circumstances one.
I also think the government has been very lacking in giving this vital information to the citizens considering we all will be paying for their actions for decades to come.
Obviously sovereign debt should be paid, but this unsecured debt, why are we paying it again???
thanks
thanks
Thats exactly what struck me in all this. Where is the information campaign by the government to explain the whole banking collapse. We are being asked to take hit after hit and nobody in government has said we have to explain to people what we are doing and why if we to keep taking money off them and services. The people have been treated like pawns by this government because we are apparently not important enough to inform that our country is Bankrupt and why.
Great article Gavan, thanks!
An informative article, however can we elaborate on the difference between secured and unsecured debt please?
I dont think ( I may be wrong)the anonymous gamblers who invested in Anglo and are being repaid even though they were “unsecured” investors are the same bondholders who loan to to us to finance the state.
It is critical we understand this, if someone could please clarify
Also surely we could have diferrentaited between the gamblers and honest bondholders like credit unions when paying them back, why are they cloaked in mystery?
Thanks Gavin. That basically explains it for me.
You missed a v. Important point…
Most of the bonds buyer are bound by the grade of the debt issued by 3 major credit agencies… By policy they can buy high grade at low yield and they are forbidden from buying ‘junk’ at any yield… Reducing demand and increasing yields. In addition most are insured with credit default swaps, where you pay a premium to a bank that if the country defaults your investment will be returned, which is why we can’t default every bank would be thrown into turmoil covering C/Ds on Irish bonds and the fear would spread to Italy, Spain etc… and eventually even Germany and the USA…
Up next, Chapter 2… Eurobonds ‘weaving the financial problems deeper’
Is there anything to be said for defaulting…………
This has not explained anything to me to be honest Gavin..it doent diffentiate between secured and unsecured debt…pathetic to see all the spin doctors agreeing with you
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