How the Bond Markets Work (Part 2 of 3)

In the first article we explained the basics about how governments borrow from "the bond markets" and how this puts our democratically-elected governments "in hock to" these markets. It makes them unduly reliant upon, and often subservient to, these markets.

In this second article we'll examine how the bond markets work in a little more depth, in order to properly understand how markets can cause "panic" and intentionally bring down or destabilise democratically-elected governments to the detriment of democracy, society and nations themselves.

Learning the definitions: There are a lot of technical terms used in this field, and there are often several different terms for the same thing. It's almost like a secret jargon to keep out the uninitiated!

So let's first explain all the critical ones.

Stylistically, in this article, we capitalise the Terms when we first describe them, and we keep them in lower case when we use the terms again. We are also referring to interest rates in a rounded manner such as 10% or 20% for simplification. In reality the rates are lower.

TAKEAWAY: There is a "primary market" where the government sells bonds to investors. There is a "secondary market" where investors sell these bonds to each other.

As the price of a bond in the secondary market falls, so its "yield" goes up in the secondary market. As its yield goes up, so the interest rates offered by the government on its new bonds in the primary market must also go up.

That is, "the interest payments on the national debt" are going up.

This means the government has to find the additional money to pay this interest to the investors. It can only find this money by putting up taxes even further, cutting spending, and issuing even more bonds. The effort to find this money to repay the interest can become a very big problem for governments, taxpayers and society!

Let's break that down.

What is an "Investor"?

When we speak about "Investors", we are referring to the people who buy the bonds from the government with the intention of making a profit by being paid regular interest payments and eventually receiving all their money back.

This process can be described as the government "borrowing" money from the investors, and the investors "lending" money to the government. Or it can be described as the government "selling" the bonds to the investors and the investors "buying" the bonds from the government.

Anyone with some spare money can be an investor in government bonds, but we're mainly speaking here about "big investors" – people and institutions with millions and billions of pounds.

What is a Government Bond?

The bond is a promise to pay back to the investor the principal sum at its maturity date, plus specified fixed interest payments at various intervals, as detailed on the bond.

In the UK, bonds can be called "Government Bonds" or "Sovereign Bonds" or "Gilts" or "Gilt-Edged Securities". These bonds can also be referred to as "Government Debt". (In the USA they're called "Treasury Bills".)

Since the interest is fixed, this means that inflation can reduce the value of these bonds over time. That is, as inflation increases, then the relative value of your fixed annual payment is decreasing. It's not going to be worth as much. Ideally, you don't want any inflation, in order that the bond retains its value for its duration.

"Servicing the Debt"

To "service" means to pay the interest on the bonds.

"Increasing the Cost of Government Borrowing"

The fixed interest rate which the government has to pay on its new bonds can be relatively high, or low. When it is high, this can be described as "increasing the cost of government borrowing" because the government has a higher interest rate to pay on the bond.

The government does not want the cost of its borrowing to increase because it means it has to find more money from the rest of society in order to service these interest payments. It finds this money by increasing taxes, and/or cutting spending, and/or borrowing even more.

How often are Bonds Sold?

The UK Debt Management Office (DMO) holds auctions for bonds, often on Fridays, and auctions for longer-term bonds periodically. They are primarily bought in bulk by extremely wealthy and large financial institutions, foreign countries, and millionaire traders, although individuals, who have some spare money, can buy them also. They are considered the safest investments for small investors.

Primary Market and Secondary Market

This is important to understand. There are two markets for bonds. Without grasping the two markets, it is impossible to understand what is going on. It is important to always make the distinction.

The Primary Market is the purchase of bond, by investors, from the DMO.

The Secondary Market is where investors can buy and sell the bonds among themselves. These are the bonds which they have already bought from the government in the primary market.

Why do Investors Sell in the Secondary Market?

An investor may sell the bond to get all the money from the bond right now, rather than waiting months or years until it matures. This is called "exiting an investment". It can also be called "liquidating your gilt holdings" – a fancy phrase for selling your bonds to get the money. As you can see, a lot of these phrases are deliberately obtuse in order to hide what is happening behind a sort of secret language understood only by the initiated.

Many investors are regularly buying and selling bonds in order to try to make money from short-term price movements; or as they like to euphemistically put it "take advantage of price fluctuations for capital gains".

Investors may also try to sell their bonds in the secondary market if they suddenly lose confidence in the ability of the government's ability to pay them back in the future. When this happens, the secondary market can be flooded with bonds and the price of the bonds in this secondary market will fall.

If the investors think that inflation is coming, then they will sell their bonds in order to get the money now before the bonds lose their value.

Where Does the Money Come from to Pay the Interest on the Bond, and also to Repay the Principal when it Matures?

The government will attempt to use taxes as the primary means to repay the interest. However, repayment of the principal is often funded by new borrowed money! That is, the government will continue to issue new bonds in order to raise the new money. Borrowing from Peter to pay Paul is called "refinancing the debt" or "rolling it over". The constant aim of any government is to try to keep this rollover amount as low as possible.

"Face Value" versus "Market Price" of the Bond

The initial cost of the bond in the primary market is called the "Face Value" price (or Par Value price). This is the value which is written on it, for example, £100.

This is different from the "Market Price" – which is the price which the secondary market deems it is worth.

For example, in the primary market, you will usually pay the Face Value. But you may be able to get it cheaper (at a Discount) or, less commonly, more expensively (at a Premium).

In the secondary market, the market price of the bond will always fluctuate. Prices depend upon investor demand, the credit rating of the nation, the bond's time to maturity, and the "yield" (see below).

When we speak about bond prices, it's important to distinguish between its "face value price" in the primary market and its "market price". The market price of the bond is the price that someone will pay for the bond in the secondary market.

"Fixed Interest Rate" of the Bond

This is also called the "Fixed Payment Interest Rate" or "Coupon Rate" or just "Coupon".

For example, if you buy a £100 bond with a 10% coupon, the government will pay you £10 per year (£100 x 10%) until the bond matures. When it matures, you will also get the £100 principal back. It is not to be confused with the "Market Interest Rate" (aka the "Yield", see below).

The "Coupon Payment" on the Bond

This is the word for the specific fixed amount of money which you are paid annually by the government on the bond. In the above case, £10. The coupon payment is fixed by the government and it won't change.

Relevance of Central Bank's "Base Interest Rate"

The fixed interest on the government bond is a different matter from the "Base Interest Rate" which is set by the Central Bank and which affects the rate at which commercial banks will lend money.

The Central Bank's base rate does not bear any relation to the yield (market interest rate) on the bond in the secondary market.

However, investors will take note of the various interest rates offered by government bonds, versus the commercial banks' interest rates – which are guided by the base rate – in order to determine where best to invest their money, and this can have an effect on the interest rate offered by the bond.

For example, if the central bank puts up the base rate, then the new bonds will be issued with higher fixed interest rates, in order to be competitive with other interest-bearing investments offered by the commercial banks in the rest of society. After all, if your bank is offering you a 10% return on your savings account then there would be no reason for you to buy bonds which offer a lower interest rate.

How are the New Fixed Interest Rates on Bonds in the Primary Market Determined?

As above, investors will take note of the interest rates being offered by the commercial banks' savings accounts.

However, the new fixed interest rates on the bonds will be found via an auction process. Investors bid based on the price and fixed interest rate they want.

Investors will also demand higher fixed interest rates on the bonds if they fear that future inflation is likely to reduce the value of these bonds.

Furthermore, if it is a long-term bond with several years until maturity, then this will require a higher fixed interest rate in order to reflect the increased risk of holding the bond for a longer time.

"Yield" of the Bond (aka the "Market Interest Rate")

The yield is also called the "Market Interest Rate" or the "Effective Interest Rate".

The yield is measured as a percentage of the price you paid for the bond in the secondary market, rather than its initial face value.

The Formula for a bond's "Yield", expressed as a percentage, is:

Yield = Annual Fixed Coupon Payment / Current Market Price of Bond

It measures the annual return an investor can expect to receive based on the bond's current market price, rather than its initial face value.

As we say, it is not to be confused with the "Fixed Interest Rate" on the bond. In the above example, the government will always pay you the 10% fixed interest rate until the bond matures. You will always get your £10 a year until it matures.

However, the bond's "yield" depends upon the price you paid for the bond in the secondary market and will usually differ from the fixed interest figure. That's why it is called the "market" interest rate because it reflects the price that the market will pay for the bond, rather than the "fixed" interest rate that the government is paying on the bond.

Often economic articles can use the phrase "interest rates" without specifying whether these are the "fixed interest rates" on the bonds, or whether it is the "market interest rate" – the yield of the bond in the secondary market. We will always make the distinction between the two.

It's a critical fact – which we'll explain further on – that as the bond's market price rises in the secondary market, the bond's yield will go down. Similarly, as the bond's market price falls, the bond's yield will go up, as per our worked examples below.

The relevance of "Bond Yields" will become clear when we explain how "Bond Vigilantes" work to attack policies and governments which they don't like. In the meantime, let's use an example to illustrate how a bond's yield changes.

CALCULATING bond "YIELD"

Please note, in this example, we are simplifying the numbers and exaggerating the interest rate figures simply for ease of understanding. In reality, the changes in interest rates are often very small.

We use the Formula for a bond's "Yield", expressed as a percentage:

Yield = Annual Fixed Coupon Payment / Current Market Price of Bond

Example 1: If the Interest Rates on new Bonds go Up

Say you bought a £100 bond which promised 10% back. You'll get £10 return each year until the bond matures.

However, if interest rates on new £100 government bonds go up to 20%, then you are stuck with only getting £10 back on this bond. Furthermore, in the secondary market, people are not going to want to buy your £100 bond from you at £100, when it only offers them a £10 return. After all, for £100, they can get a return of 20% (equivalent to £20) by buying the new government bonds right now. Why should they buy yours?

So what happens?

If you have a £100 bond which offers only 10%, then people will still be prepared to buy it from you, but only at a discount. For example, they will buy it from you for no more than a market price of £50, since a £10 return from a bond which costs £50 is equivalent to the current 20% interest rate return. So if you are selling it, then you are going to have to take a loss on your bond.

In this case, the bond's "Yield" can be calculated via our formula:

Yield = Annual Fixed Coupon Payment / Current Market Price of Bond

Yield = £10 / £50 = 20%

Ideally, they will try to buy it at even less. Say £40, giving them a "Yield" of 10/ 40 = 25%.

Note how as the market price of the bond goes down, the percentage yield of the bond goes up. They will try to drive the price of the bond down, so that their yield increases.

Example 2: If the Interest Rates on new Bonds go Down

Using the same example of your £100 bond which promised 10% back; that is, £10 each year until the bond matures.

Say, in the interim, the interest rates offered on new £100 government bonds falls to 5%, then you will continue to get £10 a year because you will legally get whatever it says on the bond you bought.

Therefore, it's been a good investment for you since everyone else is only getting 5% on their new government bonds.

This will make your bond attractive for sale in the secondary market. People will want to get 10% on that bond when they can only get 5% on the new ones.

So how much will they be willing to pay, over and above its face value?

Ideally, they would like to just purchase it off you for £100 and get a straight 10% (£10) return. However, why would you sell at that price and gain nothing? You want to charge more than its £100 face value. You want to charge what is called "a premium". You want to be selling it at more than its face value.

From the buyer's perspective, they want to pay what will end up giving them a return of the current market interest rate of 5%, but no more.

In order to determine the maximum price that we would pay, we use the principle that the market price that we're willing to pay for the bond must adjust to the point that its original fixed payment interest rate matches the current market interest rate.

The formula is expressed as:

Maximum Price to Pay = Original Coupon Payment / New Interest Rate %

In this case:

Maximum Price to Pay = £10/ 5% = £200 (ie 10 / 0.05 = 200)

So if the old bond will give us a £10 payout, then we'll pay up to £200 for it, since 5% of £200 is £10. We won't pay any more for this since then we'd start to lose money.

For example, if say, we paid £210, then – using our formula for yield:

Yield = Annual Fixed Coupon Payment / Current Market Price of Bond

£10 / 210 = 4.76%.

There would be no point in doing that since 4.76% would be less than the 5% we can get from the government in the primary market!

Note that as the price we pay for the bond goes up, the % yield goes down.

Ideally, we'd like to pay much less than this. For example, if we paid only £150 for it, this would be a yield of

£10 / 150 = 6.67%

As we see, as the price we pay for the bond goes down, the % yield goes up.

In reality, bonds are being traded constantly and minute fluctuations in % yield for specific bonds are occurring all the time.

From Our Position as an Investor

The point to remember is that as the price of bonds in the secondary market go down, the yield goes up, and as the price of bonds go up, the yield goes down.

From our perspective as an investor, we want the highest yield possible, and so we want to pay the lowest possible price for the bonds in the secondary market.

Why the "Yield" on Bonds Matters to the Government

If the yield on particular bonds in the secondary market is high, then this figure – which represents the interest rate that the market is getting for the bonds in the secondary market – will be the figure which will guide the government when it is setting the fixed interest rate on new bonds which it will sell to the bond market again.

It will guide the government because the yield figure is indicating that (as per the example above) the market is trading £100 bonds at a 20% yield.

Therefore, the market is not going to buy £100 bonds from the government which offer a return of 10% (£10 a year) when such bonds can be bought in the secondary market for only £50.

So the government has to offer higher interest rates to attract investors to its new bonds.

Thus there is an alignment between the yield in the secondary market for a particular bond, and the fixed interest rate on the bond which the government must set on new bonds in the primary market.

Basically, the fixed interest rate on new bonds in the primary market will seek to track the yield of the bonds in the secondary market.

As above, as the price of bonds decreases in the secondary market, and as the yield rises, then there is a constant pressure on the government to put up the fixed rate of interest on all its bonds.

This is problematic for the government because the government will ultimately have to find that extra money to pay these higher fixed interest payments. This is called "increasing the cost of government borrowing". It will lead to a higher "national debt".

So basically, when bond prices fall in the secondary market, then there is pressure on the government to put up interest rates on its new bonds. However, this means it creates even more pressure on the government to try find the new money somewhere to service the interest on these bonds – which means higher taxes and more "cuts", and inevitably falling back on having to issue even more bonds, which increases the national debt even more.

This causes problems for all of us as we are forced to suffer higher taxes, and cuts to our public services.

The Power of the Bond Markets to Cause Mischief

It follows that if someone wants to crash the government or force it to change a policy course, or even just to hurt, or punish, the people of a nation – then extremely wealthy financial institutions and individuals can sell off the bonds which they've been holding. They can "flood the secondary market" with the bonds which will reduce the price of the bonds.

This will cause the yield on these bonds to rise, which will require the government to put up fixed interest rates on the new bonds in the primary market.

This will cause maximum distress to the government as it struggles to figure out where it is going to find the additional money to service these high interest bonds (ie find the money to pay the interest), as well as cause maximum distress to people in society through tax raises and spending cuts, and political instability!

What is a Bond Vigilante?

This is the term for such investors who use their control of large amounts of these government bonds to sell them off with the aim of causing the above problems. Let's examine them in article 3.