I thought it high time I made a few comments on bonds and bond markets. These are designed to explain in the simplest terms what a bond is , how its price as affected and why in the euro zone crisis, Government (or Sovereign bonds as they are also called) have played such a big part.
What is a bond?
To raise money, governments, government agencies, municipalities, and corporations can sell bonds. When you buy a bond, you’re essentially lending money to this entity for the promise of repayment in addition to a specified annual return ( the interest rate or coupon as it used to be known). They are really just an IOU but have been called debt securities, fixed income securities as well as plain bonds: In may countries they have adopted names for their government bonds. Treasuries in US , Gilts in the UK ( Short for Gilt edged ) Bunds in Germany etc.
What are the risks?
When you buy a bond you have an interest rate risk. The price of the bond will go down if interest rates go up and up if interest rates are lower. They also have a counterparty risk which is the likelihood of the bond issuer being able to pay you back.
Interest rate risk example.
If you bought a 10 year bond at 5%. You should receive 5% interest per annum until maturity. If during that period interest rates moved higher ( could be short term and or long term rates) the price of the bond would be lower than 100 ( Issue price). So if rates moved to say 8% and you sold your bonds before maturity you would not receive 100% of the sum invested. If you hold till maturity you will (provided the counterparty is still solvent).During this period the effective yield on this bond will be 8%. i.e. someone who bought some would still just get the 5% interest but would pay less than 100% for the bond ( A yield of 8% on a 5% coupon bond would have the price of around 78.50. Every 100 of whatever currency bond you bought would cost just 78.50). The opposite is true if the interest rates go the other way. The bond price would be above 100 the yield would fall below the coupon ( Issued interest rate).
The effects on the price of a bond will be identical when perceived counterparty risk changes. If a corporation or country becomes less credit worthy and more risky their bonds will lose value pushing the effective yield up and price down. Conversely the so called Junk bonds which are traded on riskier companies normally can bring rewards of higher prices if the outlook for that company improves.
Other influences on prices.
Recently the US Federal reserve and the Bank of England have adopted the policy of Quantative Easing (QE). This policy involves the central banks buying up huge amounts of bonds so that cash is put back into the system. Because of the size of these purchases they have had the effect of forcing the yields on bonds down ( prices up)
How bond yields can affect forex markets
Foreign exchange prices between countries have always been influenced by interest rates be they short term or long term rates. Long term rates are reflected mostly in what government bond yields are. If country A has higher interest rates than country B then international investors may invest in country A because of the higher return. However, during a crisis and particularly one of confidence it may not matter what rate of return is being offered if investors feel the bonds are too risky. Typically we see a rush into US treasuries ( US government bonds) or a flight to safety when there is uncertainty even if the yields on those bonds are substantially lower
What happened in the euro zone.
During the early years following the Euros inception bond yields in member countries converged. There was a view that Greek, Spanish ,Portuguese or Italian bonds were as safe as German bonds. A surrogate bond if you like that paid just a bit more interest . All were considered risk free and banks were encouraged to invest by central banks on that view. The problems with Greece changed all that and was quickly followed by Ireland and Portugal who like Greece were bailed out when borrowing levels in bond markets became to high and unsustainable.The trust has been broken and suddenly banks find themselves with so called risk free assets that have declined dramatically in price and may just not be risk free. This was proved by the so called haircut on Greek debt which will see a write-down by banks. Now the genie is out of the bottle the risk associated with other euro zone bonds has been highlighted by widening spreads with German government bonds. In the last several months German bond yields have declined a little but Italian and Spanish bond yield have moved higher. Thus the difference or spread has widened.
Unless the European Central Bank (ECB) supports these markets it is feared that Italy and Spain may be forced into bailout territory. These tensions are adding to the woes of European banks who find themselves under capitalised, shut out of funding markets and quite literally unable to function properly as lenders. This is what is known as a credit crunch. It will suffocate growth at a time when austerity drives by governments are also slowing activity. As we have seen in Greece a downwards spiral of economic decline which seems impossible to stop.