Bond round-up


No, no, no … the bond markets. Read on, please.

Basically two things are going on with bonds right now. But to explain them, maybe I should first talk about what a bond is. Simply put, a bond is an instrument offered for sale when the seller (a business, or a municipality, or perhaps a national treasury) needs to raise cash money. The bond is effectively a promise by the seller to pay the buyer back his original purchase price, plus interest, at a certain date in the future (the maturity date). Government bonds can be traded in an “open market” between a central bank (like the Federal Reserve) and the private banks that it regulates, as an effective method of controlling available currency. Government bonds can also be auctioned, or they can be traded — just as municipal and corporate bonds are traded — in a regulated free market (like stocks and commodities futures) where price is adjusted according to supply and demand.

Buyers are enticed to buy bonds based on a combination of the risk associated with the bond and the interest rate that it pays. The lower the risk, the lower the interest rate can be; the higher the risk, the higher the interest rate must be in order to offset the higher risk. Bonds that are issued by the governments of nations with stable economies, or by large profitable corporations, are considered to be very low risk investments. A bond’s value is also affected by its interest yield, compared to current interest rates (if interest rates fall, for example, then older bonds that pay yields at the old higher rates become more valuable) and by the amount of time remaining until its maturity date.

For fiscal year 2009 – 2010, the United States government will spend so much money that it will have to borrow roughly 60 cents of every dollar it spends. In order to raise that much money, our government will have to sell a lot of bonds. A lot of them. But the amount of debt that we are accruing because of all of this deficit spending is making bondholders nervous. During the last few weeks, there has been much talk of long-term US Treasury bonds losing their AAA rating.

If investors around the world (read: China) are skittish about buying long-term US Treasury bonds (10, 20, and 30 year maturity) because of uncertainties about the robustness of the US economy, then our bonds will have to be made more attractive. This would be accomplished most easily by raising their interest yield. But increasing the interest we have to pay to US Treasury bondholders necessarily makes money more expensive, which means that interest rates charged by lenders will also increase. Credit cards, mortgages, car loans, business loans, etc. will all cost more.

If the government can’t sell enough bonds, they can always print more money. But printing money that is not backed by capital always causes inflation. What’s worse, inflation caused by artificially increasing the money supply, combined with steadily rising interest rates, will certainly lead to prolonged economic stagnation and perhaps the dreaded curse of “stagflation” — steadily rising prices and interest rates in an economy that is either stagnant or shrinking. When that happens, net wealth plummets. Think 1979.

So now you see the problem. Over at The Atlantic, the indispensable Meagan McArdle writes:

Up until now, most of the debate over the administration’s spending plans has focused on the political problem: will the American public accept higher spending? But the problem isn’t the spending; it’s how to pay for it. If the spending were attached to tax hikes, this would cut into its popularity (though I don’t know by how much). That’s one of the reasons that administrations like to fund their new spending with borrowing. But you can’t long do this on a scale that freaks out the bond markets–just ask Argentina. And these days, the bond markets are easily freaked.

Robert Stacy McCain
puts it this way:

When the government prints currency, the mere act of printing does not create capital.

What we are dealing with, in this recession, is a capital shortage. The collapse of the housing bubble wiped out a massive amount of value. People had borrowed money against that value, and the creditors whose capital was invested in those loans are now trying to figure out exactly how many cents on the dollar they might be able to collect, and how soon.

Ergo, there is a severe liquidity crunch, which the federal government is attempting to remedy through deficit spending. But deficit spending is borrowing, and so money that might otherwise be invested in the (job-creating, growth-inducing) private sector is instead being siphoned off into government bonds.

Something is wrong here. Whatever the result of such a policy, it will not be economic growth.

That’s the first bond problem. The second major bond problem has to do with corporate bonds, specifically the value of corporate bonds in light of the Obama Administration’s forced bankruptcy negotiations involving GM and Chrysler. During those negotiations, the Obama White House pressured Chrysler’s corporate bond holders to settle for 30 cents on the dollar of what they had invested in those bonds. But those bonds were sold to buyers as “secured” investments; in other words, in the event of bankruptcy, secure bondholders would be first in line to recover their investments. President Obama himself went so far as to characterize those who opposed losing 70% of the money they invested in Chrysler as “greedy.”

But who holds Chrysler’s bonds — and the bonds issued by every other major US corporation? People like Teresa Waller, a 58 year old Texas resident who put much of her remaining retirement funds into “safe” corporate bonds, after losing 40% of it in last year’s stock market meltdown. Or investment funds like the Indiana Teachers Retirement Fund, which lost $4.6 million by investing in Chrysler bonds.

If the Obama Administration believes that it now has the power (and perhaps the duty) to nullify secured corporate bond status and distribute assets with no regard to established bankruptcy law, then how will the bond markets react? If secured corporate bonds are no longer viewed as a safe investment, then their market value will plummet, making it much harder for businesses to raise cash by selling bonds. And this could hit unionized industries especially hard, since the fact that UAW received most of the gravy from the Chrysler bankruptcy settlement would guarantee a high risk assessment for those companies. So much for protecting the little guy.

Neither of these two scenarios involving bonds looks to have a happy ending at this point. I’m not going to go as far as comparing the US to Zimbabwe or Argentina, since both of those nations faced great economic and government instability (including civil wars and violent revolution) for decades before their economies collapsed. But I will note that we have the late 1970’s as a painful reminder of the reality of stagflation, and we also have 1990’s Japan as a reminder of the consequences of heavy government borrowing with no good way to pay for it. Unless the borrowing stops, we will be in for a long, bumpy ride ahead.

Obama's Bond Market
We Are So Screwed, Part II