We’d Like to Offer You a Loan, but Only if You Don’t Borrow the Money…
It sounds like a riddle out of The Hobbit: What is only true if you don’t test it?
The answer is low interest rates in the bond market. The ability of governments to borrow on the cheap, or even get paid to borrow money.
Yes, interest rates may well be negative in Europe’s secondary market for bonds — where owners of existing government bonds sell them to other investors. A 10-year bond halfway through its lifetime, for example.
This is supposed to tell European governments that they can borrow money for five years at negative interest rates today in the primary market. But whenever they actually try to borrow, things go awry…
Germany managed to sell less than half of its zero return 30-year bonds in August.
In the US, bond auction bids to cover rates recently hit their lowest in a decade. Meaning few people wanted to lend the government money.
Japan had a similar problem earlier this month.
In the UK late last year, the government had to offer the biggest discount since 2009 to get its bonds over the line.
And last week, Australia’s government didn’t even manage to sell the government debt they put up for auction. The last time that happened was 2002.
The embarrassment was so bad the Australian Office of Financial Management had to announce ‘Today’s result is in no way a default by the Commonwealth of Australia.’ Yikes!
The ice underneath Merkel, Trump, Abe, Boris, and Scott is creaking.
But what’s actually going on here? Why are investors willing to buy bonds at ridiculous prices from other investors, but when it comes to lending the government money the demand evaporates?
I think the distinction lies in the difference between the secondary and primary market in government bonds. The sort of thing you forget after the end of term exam. But for once, I may have learned something useful at school…
Bonds in the secondary market tend to pay a coupon every six months, despite their low or negative yield. That’s because, when they were issued, interest rates were still decent. (The coupon is fixed for the life of the bond.)
Currently, an Aussie bond which matures in 2047 has a coupon of 3% per year, despite a yield below 2%, for example. This is different to a bond issued today with a coupon of less than 2%, which matures on the same day in 2047. The timing of the cash flow over the life of the two bonds is different, even if their yield is the same in the end.
Investors in 3% coupon bonds get paid a higher return every six months. It’s when the bond matures that investors lose money. Because they only get paid back the par value.
But if you plan on selling the bond well before then, you are able to make off with a decent coupon income in the meantime.
It’s only a loss if you don’t sell it early enough
In other words, a negative yielding bond can actually pay a decent income. And if you sell it long before it comes due, you might be able to evade the loss.
The saying ‘it’s only a loss if you sell it’, becomes ‘it’s only a loss if you don’t sell it early enough.’
It seems to me that the factors which set prices in the secondary market are not the same as the factors setting prices in the primary market. Trading in bonds is different, for some reason, to actively lending the government money.
What does all this mean for the world around you and what impacts you each day?
The first lesson is that government bond yields are only low for as long as governments don’t actually try to take advantage of them. It’s a bit like your credit score. It’s only good while you don’t use it.
This means I’m issuing two warnings to you today.
If fiscal stimulus hits the news cycle, you can expect bond yields to rise, fast. This suggests that bond markets might enforce austerity surprisingly quickly.
The fiscal stimulus which central bankers are trying to get their politicians to undergo might outright panic the bond market. And higher interest rates on government bonds quickly spreads into the rest of the economy.
Secondly, the Green New Deal to save the planet, which politicians want to finance with debt, would end up costing a lot of interest once governments actually tried to borrow the money.
In short, the low interest rates in the bond market are a mirage. Bond markets are far more fragile than they seem. The ability of governments to borrow only appears strong. Don’t believe the low interest rate lie.
Until next time,