Our economic times: The importance of the bond market

In a time when terms like “sovereign debt crisis,” “fiscal cliff” and “insolvency,” capture headlines around the world, the central role of credit markets in our global economy cannot be overstated.

The U.S. financial crisis that began in 2007 and current European debt crisis share a strong link: National governments on an unsustainable debt path, forced to rescue and buoy a grossly overleveraged private sector, find themselves at the mercy of bond markets dictating the cost of such expenditures going forward.

Investors’ willingness to lend to the two struggling regions, however, could not be more different.

The divergence in borrowing costs, or yields, across the pond has been remarkable. Countries such as Greece, Italy, Portugal and Spain — in dire need of capital to avoid fiscal insolvency — have witnessed borrowing costs escalate while markets have extolled the borrowing credibility of our domestic government with historically low bond yields.

This, among other things, suggests the U.S. government remains one of the top candidates in the world to lend to. The United States and other governments borrow by issuing debt contracts with different maturities. The contracts are in essence an IOU to the lender detailing the amount to be paid when the debt matures, or face value, and the semi-annual payment to lenders for parting with funds, or coupon rate, which is closely tied to prevailing interest rates.

If investors perceive the borrowing nation to lack any credibility or are engulfed in fiscal turmoil, they will require a greater rate of return, or higher interest rate, to hold that nation’s debt. To make existing and newly issued bonds attractive to investors, bond prices must decrease. This exemplifies the inverse relationship between bond prices and interest rates.

Bond auctions over the last year have showed little investor enthusiasm for holding Greek, Italian, Portuguese and Spanish debt — the major players in the European sovereign debt crisis of 2012.

These countries, reliant on credit markets to fund maturing debt and ongoing interest payments, are being punished day after day with escalating borrowing costs with most countries eclipsing the dreaded 7 percent threshold yield at some point over the past three years. At the time of writing, 10-year yields for these countries sit at 27 percent, 5.8 percent, 9.5 percent and 6.4 percent respectively.

The Eurozone’s largest nation, Germany, has enjoyed diminishing borrowing costs over the previous four years and faces a current 10-year yield of 1.58 percent.

Alternatively, in the last three years, the U.S. bond market has been perceived as a safe haven from an often-volatile and weary stock market. Investors in domestic bond markets have determined that it costs the U.S. 1.66 percent to borrow over a 10 year period. This is relatively cheap compared to the periphery nations of the Eurozone but on par with the borrowing ability of Germany.

So why the disparity in borrowing costs, not only within the Eurozone, but across the Atlantic as well? First, and most obvious, is the heightened chance of debt default by nations such as Greece and Spain relative to Germany and the U.S., whose likelihood of such a scenario occurring is nearly negligible. Borrower default is a key risk any lender faces in the bond market.

Second, the fiscal and monetary structure of the Eurozone is dissimilar and, perhaps, fundamentally flawed, compared to that of the U.S. With the introduction of the euro, the region’s single currency, in 1999, the organization of the member nations has been one of shared currency and monetary policy but one of differential governments. Compare this to the U.S. with also one currency but one overarching national government.

The majority of the current troubles in Europe can be traced to this poignant distinction. Eurozone countries have been able to pursue autonomous fiscal policies at their own discretion, while the reigns of monetary policy, and the Euro currency, have been controlled by the European Central Bank, headquartered in Frankfurt, Germany.

Even though the U.S. suffers from a rather cantankerous political system where, at times, very little seems to be accomplished, the course of monetary policy is coupled with the actions of one administration, not 17.
