bonds - Economics Help

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?

bond-government-us

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.

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.

When the Fed buys bonds, the greater demand pushes up the price of bonds.
However, with an increase in the price of bonds, the bond yield falls.
There is an explanation here why there is an inverse relationship between the price of bonds and the yield of bonds.

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)