Tag Archives | bonds

What happens when the government runs out of money?

Readers Question: Since the debt is mainly in the form of government bonds or gilts then it can only be paid back when the term of the bond terminates. What happens if there is not enough money to pay this back?

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Government bonds are a method for the government to borrow money. They sell bonds (e.g. for £1,000) and promise to pay back the bond holder in say 30 years. In the meantime, they will pay an interest rate of e.g. 5% a year as compensation.

Default on debt. If the government has no money to pay bond holders, then it will be defaulting on its debt. Bond holders lose their investment.

The government will be reluctant to do this because once it has started to default on its debt – no-one will want to buy or hold government bonds – so you will see the price of government bonds fall, and the market interest rate rise. The government will have to pay much higher interest rates to compensate for the risk of default and it will be difficult to attract buyers of bonds in the future.

Haircut / partial default. If the government is in great financial difficulty it may offer a deal to bond holders that it will pay back a certain percentage, e.g. 50%. In response for writing off 50% of the bond, bondholders may feel it is better to get 50% than nothing. Alternatively, the government may extend the maturity of the bond, e.g. change a 30 year bond into a 45 year bond, to give itself more time to pay it back.
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Why Fed Tapering caused a rise in bond yields

Readers Question Why did bond yields in the USA rise at news of the Fed Tapering back in August?

The Federal Reserve has been engaged in a policy of quantitative easing. This involves:

  • Creating money electronically
  • Using this created money to buy assets, such as government bonds.

The aim of quantitative easing is to stimulate economic activity – increase economic growth and avoid inflationary pressure. QE aims to stimulate economic growth through increasing the money supply and reducing interest rates in the economy.

With the Federal Reserve buying bonds, other investors are also keener to buy bonds. The Fed is pushing up the price of bonds so whilst this is occurring other investors may be encouraged to also buy bonds and benefit from the rising prices.

Fed Tapering

Fed Tapering means that the Federal Reserve will begin to stop buying bonds, and no longer continue to create money and buy bonds. This tapering could also be seen as a preliminary to reversing quantitative easing and selling the bonds that have been accumulated.

A decision that the Fed would be beginning to end quantitative easing, will encourage investors to start selling bonds.

If the Fed stops buying bonds, the price is likely to stop rising; and if quantitative easing is reversed,  bond prices could fall. This expectation of falling bond prices will encourage investors to sell. Markets are always trying to anticipate future movements. Therefore, even a weak signal that bond purchases may start to be tapered was seen as a signal that now would be a good time to sell bonds and move into something else.

As bond prices fell, the yield started to rise (the inverse relationship again) Continue Reading →

Would it Help to Buy Bonds from the Government?

Readers Question: If all Greeks native or from abroad (or any other country in debt) bought their own bonds would this make the debt much lower?

No, it would not make the debt any lower. But, it would help to finance the government’s deficit. It would make it easier for the government to avoid a debt crisis. If sufficient people bought government bonds then it would reduce the interest rate on government bonds. The advantage of this would be:

  • Lower bond yields (lower interest payments) saves the government money. Many European countries suffering a debt crisis are hurt by the cost of servicing their debt interest payments. This is particularly a problem for countries like Greece, Spain and Italy where bond yields (the cost of borrowing) are close to 7%. If these interest payments could be used to repay debt, it would be much easier to reduce the debt to GDP ratio.
  • It would give the government more time to reduce debt without painful austerity measures. Greece is probably too late. But, European countries with high debt ratios were forced to pursue austerity measures to try and reduce the deficit. These austerity measures led to lower economic growth (and lower tax receipts) and harmed the state of the economy. But, if the private sector buy bonds there is less pressure to cut spending.
  • Reduce the need for a foreign bailout. Countries like Spain and Italy may require some kind of foreign bailout. This is when they borrow from the EU or IMF to meet their shortfall. The problem with having to borrow from abroad is that lenders (e.g. IMF, EU) are likely to insist on certain criteria (e.g. spending cuts, privatisation) as part of the deal. If citizens bought sufficient bonds, then there would not be this need to borrow from abroad.

Italian campaign to buy Government bonds.

In Italy, there is campaign to encourage people to be patriotic and buy government bonds. (e.g. Italian footballers encouraged to buy bonds). Italy’s debt is a paradox, their total amount of debt (private + public) is quite low by international standards. They have a primary budget surplus. So if successful, the government could see a significant reduction in borrowing costs, and it could help to avoid a debt crisis.

The problem is that if some patriotic investors buy bonds, other investors may take advantage and sell their bonds as the price rises. It would require a huge intervention from ordinary investors to overcome the Italian debt crisis.

Would it Work in Greece?

I’m not sure if Greece could avoid a debt crisis. The scale of government debt is so large, I don’t know if there are sufficient levels of private sector saving in Greece to rescue the situation. i.e. even if everyone used every saving to buy Greek government bonds, it may still not be enough for the government to avoid default. It depends on level of private sector savings compared to government debt.

Would Printing Money Reduce the Value of Debt?

A country with its own currency and own Central Bank could print money and use this money to finance the debt. This doesn’t reduce the debt, but it makes it much easier to finance. In a way it is reducing the real value of the debt.

The problem is that printing money could cause inflation. This would reduce value of existing bond holders. Investors may become very reluctant to buy bonds from a country where the government prints money and creates inflation – Because inflation is effectively reducing the real value of savings.

However, in some circumstances, such as liquidity trap, printing money may not cause inflation and can help to avoid liquidity shortages.

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