After the creation of credit by banks, the birth of the bond was the second great revolution in the ascent of money. Governments (and large corporations) issue bonds as a way of borrowing money from a broader range of people and institutions than just banks. Take the example of a Japanese government ten-year bond
with a face value of 100,000 yen and a fixed interest rate or 'coupon' of 1.5 per cent - a tiny part of the vast 838 trillion yen mountain of public debt that Japan has accumulated, mostly since the 1980s. The bond embodies a promise by the Japanese government to pay 1.5 per cent of 100,000 yen every year for the next ten years to whoever owns the bond. The initial purchaser of the bond has the right to sell it whenever he likes at whatever price the market sets. At the time of writing, that price is around 102,333 yen. Why? Because the mighty bond market says so. From modest beginnings in the city-states of northern Italy some eight hundred years ago, the market for bonds has grown to a vast size. The total value of internationally traded bonds today is around $18 trillion. The value of bonds traded domestically (such as Japanese bonds owned by Japanese investors) is a staggering $50 trillion. All of us, whether we like it or not (and most of us do not even know it), are affected by the bond market in two important ways. First, a large part of the money we put aside for our old age ends up being invested in the bond market. Secondly, because of its huge size, and because big governments are regarded as the most reliable of borrowers, it is the bond market that sets long-term interest rates for the economy as a whole. When bond prices fall, interest rates soar, with painful consequences for all borrowers.
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| Japanese government ten-year bonds, complete with coupons |
The way it works is this. Someone has 100,000 yen they wish to save. Buying a 100,000 yen bond keeps the capital sum safe while also providing regular payments to the saver. To be precise, the bond pays a fixed rate or 'coupon' of 1.5 per cent: 1,500 yen a year in the case of a 100,000 yen bond. But the market interest rate or current yield is calculated by dividing the coupon by the market price, which is currently 102,333 yen: 1,500 -r 102,333 = J-47 Per cent.*
(NB * This should not be confused with the yield to maturity, which takes account of the amount of time before the bond is redeemed at par by the issuing government.)Now imagine a scenario in which the bond market took fright at the huge size of the Japanese government's debt. Suppose investors began to worry that Japan might be unable to meet the annual payments to which it had committed itself. Or suppose they began to worry about the health of the Japanese currency, the yen, in which bonds are denominated and in which the interest is paid. In such circumstances, the price of the bond would drop as nervous investors sold off their holdings. Buyers would only be found at a price low enough to compensate them for the increased risk of a Japanese default or currency depreciation. Let us imagine the price of our bond fell to 80,000. Then the yield would be 1,500 + 80,000 = 1.88 per cent. At a stroke, long-term interest rates for the Japanese economy as a whole would have jumped by just over two fifths of one per cent, from 1.47 per cent to 1.88. People who had invested in bonds for their retirement before the market move would be 22 per cent worse off, since their capital would have declined by as much as the bond price. And people who wanted to take out a mortgage after the market move would find themselves paying at least 0.41 per cent a year (in market parlance, 41 basis points) more. In the words of Bill Gross, who runs the world's largest bond fund at the Pacific Investment Management Company (PIMCO), 'bond markets have power because they're the fundamental base for all markets. The cost of credit, the interest rate [on a benchmark bond], ultimately determines the value of stocks, homes, all asset classes.'
From a politician's point of view, the bond market is powerful partly because it passes a daily judgement on the credibility of every government's fiscal and monetary policies. But its real power lies in its ability to punish a government with higher borrowing costs. Even an upward move of half a percentage point can hurt a government that is running a deficit, adding higher debt service to its already high expenditures. As in so many financial relationships, there is a feedback loop. The higher interest payments make the deficit even larger. The bond market raises its eyebrows even higher. The bonds sell off again. The interest rates go up again. And so on. Sooner or later the government faces three stark alternatives. Does it default on a part of its debt, fulfilling the bond market's worst fears? Or, to reassure the bond market, does it cut expenditures in some other area, upsetting voters or vested interests? Or does it try to reduce the deficit by raising taxes? The bond market began by facilitating government borrowing. In a crisis, however, it can end up dictating government policy.
So how did this 'Mr Bond' become so much more powerful than the Mr Bond created by Ian Fleming? Why, indeed, do both kinds of bond have a licence to kill?
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