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Q&A: Irish bond crisis Q&A: Why do bonds matter?
(10 days later)
By Nils Blythe BBC business correspondent Government bonds have been very much in the news in recent months.
The Irish Republic faces a crisis of confidence in the financial markets. A vital way for countries to raise funds, they can also be seen as a barometer for a government's financial health.
The "cost of borrowing" for the Irish government is rising. But what does this really mean? This is because the more concerns the markets have about a nation's public finances, the more expensive it is for that government to auction its bonds.
This is why countries such as Greece, Portugal and the Irish Republic have found it so much more costly to attract interest in their bonds this year.
What is a government bond?What is a government bond?
Governments borrow money by selling securities known as bonds to investors. In return for the investor's cash the government promises to pay a fixed rate of interest over a specific period - say 4% every year for 10 years. At the end of the period the investor is repaid the cash they originally paid, cancelling that particular bit of government debt. Government bonds have traditionally been seen as ultra-safe long-term investments and are held by pension funds, insurance companies and banks, as well as private investors.Governments borrow money by selling securities known as bonds to investors. In return for the investor's cash the government promises to pay a fixed rate of interest over a specific period - say 4% every year for 10 years. At the end of the period the investor is repaid the cash they originally paid, cancelling that particular bit of government debt. Government bonds have traditionally been seen as ultra-safe long-term investments and are held by pension funds, insurance companies and banks, as well as private investors.
What is a bond market?What is a bond market?
Once a bond has been issued - and the government has the cash - the investor can hold it and collect the interest every year until it is repayable. But investors can also sell the bond on the financial markets. The price of the bond will fluctuate as the outlook for interest rates changes. So, for example, if the markets think that interest rates are going to rise sharply, then the value of a bond paying a fixed rate of 4% for the next ten years will fall. Bond prices will also fall if investors think that there is a risk of the government that issued the bond not being able to make the annual interest payment or repay it in full on maturity - and these are the fears which have been pushing down Irish bond prices. Once a bond has been issued - and the government has the cash - the investor can hold it and collect the interest every year until it is repayable. But investors can also sell the bond on the financial markets. The price of the bond will fluctuate as the outlook for interest rates changes. So, for example, if the markets think that interest rates are going to rise sharply, then the value of a bond paying a fixed rate of 4% for the next 10 years will fall. Bond prices will also fall if investors think that there is a risk of the government that issued the bond not being able to make the annual interest payment or repay it in full on maturity - and these are the fears which have been pushing down Irish bond prices.
What is a bond yield?What is a bond yield?
This sounds complicated, but isn't! The yield is the return received by an investor who buys the bond at today's market price. Let's take an example. A bond is sold by a government for 100 euros, paying an annual interest rate of 4%, or 4 euros per year. The yield is 4%. But then the market price of the bond falls to 50 euros. The interest payment (the coupon) is still 4 euros per year. So for a 50 euro investment the investor can get a 4 euro annual payment, which is a return or "yield" of 8%. Market commentators usually quote bond yields, rather than prices. The key thing to remember is that bad news drives down bond prices, which pushes up bond yields.This sounds complicated, but isn't! The yield is the return received by an investor who buys the bond at today's market price. Let's take an example. A bond is sold by a government for 100 euros, paying an annual interest rate of 4%, or 4 euros per year. The yield is 4%. But then the market price of the bond falls to 50 euros. The interest payment (the coupon) is still 4 euros per year. So for a 50 euro investment the investor can get a 4 euro annual payment, which is a return or "yield" of 8%. Market commentators usually quote bond yields, rather than prices. The key thing to remember is that bad news drives down bond prices, which pushes up bond yields.
Why do bond markets matter?Why do bond markets matter?
Because they determine what it costs a government to borrow. When a government wants to raise new money it issues new bonds. But those bonds have to pay an annual interest rate which is close to the current yield for bonds which it has issued earlier and are now being traded in the market (see above). So if a crisis of confidence drives up market yields the government has to pay more for new borrowings - possibly a lot more. (But remember that it does not affect the cost of paying the annual interest of existing bonds, because the interest rate is fixed for the life of the bond).Because they determine what it costs a government to borrow. When a government wants to raise new money it issues new bonds. But those bonds have to pay an annual interest rate which is close to the current yield for bonds which it has issued earlier and are now being traded in the market (see above). So if a crisis of confidence drives up market yields the government has to pay more for new borrowings - possibly a lot more. (But remember that it does not affect the cost of paying the annual interest of existing bonds, because the interest rate is fixed for the life of the bond).
What has happened to Irish bonds? What has happened to Irish, Portuguese and Greek bonds?
Market prices have fallen in recent months, pushing up the yields (see above). The yield on a 10-year Irish bond reached about 9% at one point. That is very high. The UK government - in spite of all its financial difficulties - can borrow for 10 years at just over 3%. Their market prices have fallen in recent months, pushing up the yields (see above). The yield on a 10-year Irish bond reached about 9% at one point. That is very high. The UK government - in spite of all its financial difficulties - can borrow for 10 years at just over 3%.
What happens next?
The Irish government says it is "fully funded" until next June - in other words it does not have to raise new money in the bond markets until next summer, although it has also said that it intends to return to the market for new funding in January. At current market prices and yields it would be very difficult to do so.
Hence it has now turned to the International Monetary Fund and the European Union for funds.
This is what Greece did when yields on Greek bonds reached levels which effectively closed down the possibility of raising money from the bond markets.