Markets are always right, but who are the arbiters?

Here's a piece published on page 13 of today's Irish Examiner, in a Q & A on bonds. Also, check out the #bondwatch tag on Twitter. I prepared these answers for a segment I did on RTE's DriveTime earlier last week, they were suggested by Claire Prior, the producer of the show.

What is a government bond?

Bonds are pieces of debt where the bond issuer agrees to pay the bond buyer a series of cash flows over the life of the bond. If I issue a 5 year, 100 euro bond to you, paying coupons of 5%, then each year I have to give you 5 euros, and, and the end of the 5 years, when the bond ‘matures’, I give you back the original 100. That’s all there is to it. Everything else, like term structures, zero coupons, etc, is a variation, or a complication.

What is the yield? Why are we benchmarking ourselves against Germany?

The yield on a bond is calculated by dividing its coupon by its market price. The yield on the bond in the example above would be 5/100=5%. Prices can change, and bonds can be sold on from you to someone else, which might change the yield. Other factors are also very important. If you think I might default, or not pay back, the original 100, that will change the yield. We benchmark ourselves against Germany’s bonds because Germany is a relatively ‘safe’ bet in terms of government bonds. It is highly, highly unlikely Germany will default.

What is the spread?

The spread in this case is the difference between German government debt, and Irish government debt. Say German yields are 2%, and Ireland’s are 6%. The spread is 4%. Sometimes people will use yield spreads as a measure of riskiness, and occasionally you hear traders refer to spreads in terms of one hundreds of a percent or in this case 400 basis points (bps).

Why is the interest rate charged so significant – what does the 1% upward change in rate since last year say about our economy?

In our example, the interest rate has to be paid back yearly, so the country owes someone 5 euros. That 5 euros has to be paid out of taxes, or more borrowing. Paying interest on debt reduces the ability of the government to fund social services. So, rather than building a hospital for, say, 80 million euros, the Irish government will have to pay that in debt servicing next year.

We hear that this week’s bond auction was hugely oversubscribed – so if investors are so iffy about our economy why are they clamoring to buy our bonds – because it’s the best return in town?

This week’s auction of 1.5 billion euros of Irish government debt by the National Treasury Management Agency resulted in an increase in the cost of servicing the national debt in the years ahead. The auction works by allowing potential bond buyers (whose identities we can’t know) to ‘bid’ for some of the bonds on sale, at interest rates the buyers find attractive. The bond issuers want to pay the least interest possible, so they rank the bidders from lowest interest rate to highest, and get rid of all the bonds in sequence. When more bids are received than accepted, the bond issue is ‘oversubscribed’, with a bid to cover ratio of more than 1.

We hear analysts say things like “the market is always right” but who are the arbiters of the market – is it the traders?

Yes. Bond traders are, for the most part, young men in their twenties and thirties who read analysis, blogs, and chatter, and make a decision on what quantity of which product--Irish bonds, German bonds, and so forth--to buy, at what interest rate. They are not always right, but they have the power to punish countries that default on them.

Ratings agencies now have immense power – who are the analysts in ratings agencies? What’s their background for pronouncing on the health of our banking sector and economy?

They have none, except the ability to read research reports generated by stockbroking firms, economists, and government agencies. They look at past data, and make a call on whether it is more or less likely that the country in question will get into trouble over the lifetime of the bond issue.

The amounts raised in these bond auctions – 1.5billion– how much do they contribute to the costs of running our economy?

Our economy produced about 159 billion euros worth of stuff last year. Our government spent around 60 billion on health, social welfare, education, justice, and everything else. The government only took in around 35 billion in taxation receipts. To keep the show on the road, the government needs to borrow around 20 billion to support 55-60 billion euros worth of spending next year. This 1.5 billion will go towards paying salaries of doctors, nurses, Garda, and the odd economics lecturer, as well as funding services.

Some commentators have said the negative market sentiment towards Ireland is exaggerated – don’t markets have a tendency towards panic?

Yes, but in the Irish case, the concern is justified by news that Ireland’s GDP fell 1.2 per cent in the second quarter , which only adds to the anxiety, as does rumours of a default by government on holders of debt issued by Anglo Irish Bank before it was nationalised.

The holy grail would appear to be “certainty”. If the government releases a final figure for Anglo in the coming weeks will this give the market the certainty it needs and stop the “bondwatch” phenomenon?

We would all like certainty when it comes to the scale of Anglo’s losses, but that simply won’t come. We’ve had 2 years to pore over the books of this bank, and any ‘final’ figure will be just another estimate. There have been several.

A letter in this week’s Irish Times pointed out that despite having a national debt which is a massive percentage of GNP we are still considered the 2nd richest country in the EU – how are people to reconcile those two facts?

Economic statistics are always collected late. The Irish economy in 2009 had the largest Ireland had an output per capita more than 20 percent higher than the eurozone average (and more than 30 percent higher than the EU-27) In 2010, this will shrink further down, and when you remove the influence of multinationals in these statistics, the distinction shrinks further. We’re below average now in terms of adjusted output per capita.

Given that yields are at record highs and that we have enough cash to last to Q1/2 of 2011 and given current yields are “ridiculous” why are we selling debt at this time?

Our politicians have made a choice to borrow to finance current expenditure, rather than digging into savings in the form of the National Pension Reserve fund.

2 Replies to “Markets are always right, but who are the arbiters?”

  1. Hi Stephen, do you not think these bond auctions are doing more harm than good? It seems clear to me that the ECB will not let Ireland default on our debt. If I were someone with money to invest, why bother with the risky stock markets or low interest rate deposit accounts or putting it into a new business start up? Why not do the least risky thing and buy bonds?
    Therefore these bonds auctions are increasing our debt and taking money out of the economy over the medium to long term.
    And don’t even talk to me about the bond bubble taking form all over the world.

  2. Hi Mossy,

    That's a version of the 'bond vigilante' argument. You could argue that government bonds are really risky simply because the markets have priced the implied probability of default in--where default means them getting less than 100% of their money back--and this, combined with some noisy jitters, is what's driving the price.

    I honestly don't know if this is a better explanation than the markets simply looking at Ireland's fundamentals, in the context of EMU, and making a risk-return call.

Comments are closed.