JAMES Carville, the American political consultant and pundit, famously joked at the beginning of the Clinton adminis tration in the early 1990s: “I used to think if there was reincarnation, I wanted to come back as the president or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody”.
He was making an important point about the power that bond markets have. To raise money, governments depend on selling “I owe yous”, or bonds, to investors. Investors, of course, demand a return for lending this money. This (annual) return is known as the “yield”. The cost of borrowing, or the yield, has risen to unsustainable levels for many countries. This is a way for bond vigilantes, as they are sometimes referred to, to warn governments about their excessive debt levels.
At the birth of the European Union, the Maastricht Treaty stated that government debt to gross domestic product (GDP), or a country’s economic output, should not exceed 60% to ensure long-term financial stability. Huge budget deficits mean that the rising debt pile for many countries has made this figure a distant memory. The figure for Italy, Greece and Ireland is well over 100% whilst for the UK, Germany and France it stands at over 80%. Even outside Europe, many developed countries are over-indebted.
Rising bond yields have been central to the high-profile downfall of some European governments this month. Greek five-year bonds yield nearly 40% because the Greek government is very unlikely to pay back the full amount owed to bondholders. A more worrying recent development is that yields of Italian and Spanish bonds are hovering around the 7% mark.
A high cost of debt over the long term and eventual default go hand-in-hand. Highly-indebted nations such as Spain and Italy would be able to service their debts if bond yields were low. But when these economies are hardly growing, paying 7% for raising funds is simply not sustainable. It is no wonder therefore that European ministers are trying to instill confidence in the bond markets to bring these yields down.
The hefty stock market falls over the summer were, in part, a reflection of concerns surrounding excessive government indebtedness. Financial institutions, from banks to insurers, hold a lot of this debt and if a government can’t repay its debt obligations in full, these institutions have to take large losses.
Losses for banks reduce their balance sheet strength, which means to rebuild their balance sheets they will have to raise money elsewhere and retain capital rather than lending it out. This would inevitably affect economic growth as individuals and businesses struggle to borrow money at reasonable rates. Much of the economic growth since the mid-90s was fuelled by widely-available and cheap credit for consumers and companies. Whilst a default from Greece or Portugal may be manageable, the likes of Italy and Spain make up a much larger portion of the European economy.
Additionally, sharp austerity measures to address the excessive debt piles and bring down the cost of debt will affect economic growth in Europe, an important market for UK companies.
Bond vigilantes have not turned on the UK or America yet, despite alarming government borrowing levels and large budget deficits. The UK government can sell 10-year bonds and pay a yield of not-much more than 2%; very few governments have this luxury. This is, however, a luxury that may not last very long.
:: Scott Farnetti, CFA, Assistant Director at Brewin Dolphin
