By: Dr. Mike Campbell
Bonds are debt vehicles whereby governments and corporations can raise funds to finance their activities. Like any other loan, the bond issuer must pay investors interest on the money that has been invested in the bond. The yield that is payable on the bond is directly proportional to the perceived safety (i.e. likelihood of repayment at term) of the investment. At the date when the bond matures, the issuer promises to repay the investor all of the capital that they originally invested in the bond. A default occurs if the issuer cannot pay the interest due on the bonds or is unable to repay the investment in full at maturity of the bond.
Government bonds (well, stable, economically sound democratic governments, in theory at any rate) are regarded as gilt-edged investments with very low default risk. Consequently, government bonds are usually low yield vehicles and find a place in an investor’s portfolio as a low risk, guaranteed return vehicle. However, the mess that the financial community got us into with the sub-prime crisis has changed all that.
In the aftermath of the global financial crisis, ratings agencies turned their gaze onto sovereign debt which, in many countries, had spiralled out of control. Scrutiny on Greek debt forced its borrowing costs ever higher, leading to it being unable to support its borrowing needs through the market. Ultimately, Ireland and Portugal followed Greece as recipients of an EU/IMF bailout, but the problem has not gone away.
The Case of Italy
Italy has become the next candidate for a bailout since its borrowing costs on 10-year bonds has risen to an unsustainable 7%. This has rekindled talk of a Eurozone break-up with more indebted and weaker economies forced out of a rump Euro. The consequences of this to the global economy would be impossible to calculate.
Politicians are scrabbling around to find solutions to the problem, but what is needed is for the investment community to realise that by demanding ever higher yield on sovereign debt, they are cutting their own throats. Ultimately, the solution to the larger crisis is to make it crystal clear to the markets that default is a real possibility if yields push ever higher and that in those circumstances, investors will bear the brunt of the losses – after all, that is why yields get pushed up in the first place.