John Redwood is a former Secretary of State for Wales and MP for Wokingham. He writes regularly at his diary.
As someone who studies bonds and sometimes writes about them I dread the times when they become leading news items. It is usually for a bad reason. Markets can get in a panic if governments issue too much debt or if inflation takes off, hitting the value of the bonds and driving up the interest they pay the saver. It leads to a lot of fevered and often badly informed commentary on the media, as the media accept the credentials of some “experts” who struggle to explain a bond in simple language or in some cases struggle to understand the bond themselves.
A bond is a government debt. Many governments like the UK and US borrow large sums from the banks, pension funds, insurance companies and the investing public. They do so by issuing a large new debt for anyone to buy a small portion of the new big loan. The buyer gets an electronic certificate that they have bought a share of the debt which states how much interest they will get on their investment, and when they will get their money back. The UK government will borrow the money for a specified time period with a fixed repayment date (the duration of the loan) and will guarantee to pay a fixed rate of interest every six months throughout the duration of the bond. Inflation linked bonds are different.
These bonds are a convenient way for funds and savers to invest. They know exactly what rate of interest they will get, like making a fixed rate savings deposit with a bank. They know exactly when they will be repaid. More importantly, they know that if their circumstances change and they need to get their money back in a hurry, they can sell their bond to someone else in the market any time it is open. So far so good.
The catch is if you do need to sell before the repayment date, you might not get back the amount you paid the government in the first place, or the amount you paid to buy the bond in the market. If interest rates go up in the meantime the value of your bond in the market goes down, as people will want to get a higher income on your bond than you are getting. They can only do this by paying you less for the bond than the original issue price because the amount of interest paid is fixed. The interest paid is then a higher percentage of their cost of the bond than it was of your original cost of the bond. A bond with no repayment date issued with a promise to pay 1 per cent interest annually will halve if the interest rate goes up to 2 per cent, as the £1 guaranteed interest stays the same. To get 2 per cent on that bond you can only afford to pay £50 for £100 of the original issue. £1 interest is 1 per cent of £100 and 2 per cent of £50.
Where I often part company with the commentariat is when I hear them say these government bonds are safe assets. If you or your pension fund had bought the UK government’s 0.5 per cent 2061 bond at issue you would be sitting now on a 77.5 per cent loss on your original purchase price. So if you had bought £100 worth you could sell it today for just £22.40. These longer dated government loans or bonds are highly volatile. Before covid the Bank of England and the UK government issued a lot of debt at very low interest rates with repayment dates many years ahead. Once interest rates started going up to deal with a bad inflation, you were bound to lose a lot of money if holding these investments. It is true that if you wait until 2061 you will get your money back, but in the meantime you will only be getting an unacceptably low 0.5 per cent on your money when a savings deposit or a shorter dated government bond would pay several times that. If you own the 4.25 per cent UK gilt repaying in December next year you can sell your £100 worth of that for £100 today, or hold and enjoy the 4.25 per cent annual interest for the remaining year and bit when the government sends your £100 back.
It is true that a government bond from a reliable state like the UK or US is safer than some corporate bonds issued by some companies. They might go bust, or get into financial difficulties so they delay or cut the interest payments. The US and UK have met virtually all their interest payments in the past and are very likely to continue to do so. That has not been true of all other governments with some failing to meet payments when they have got into financial difficulties. Germany signed a 1953 Debt Agreement cutting some of its debt obligation by agreement with its creditors. Brazil reneged on some debts in 1987. Since 2020 Sri Lanka, Argentina, Ghana, Zambia, Ecuador, Ethiopia and Lebanon have all defaulted or suspended some payments on debts.
It is untrue to say that any government bond with a very distant repayment date is “safe”. In times like today those bonds will sell off to low prices. They can be ravaged by inflation at any point in their long lives. Both the US and UK governments are having to pay a much higher rate of interest on their borrowings today than at any time this century. That is because they have already borrowed too much and are refusing to rein in their high levels of new borrowing, which places more strains on a reluctant bond market. The danger is a doom loop, where higher interest rates drive up the amount government has to pay in interest charges on its debts, which in turn worry the markets as these could become unaffordable. That happened to the UK Labour government in the 1970 s when it ended up having to pay 15.5 per cent on one of the bonds it issued. It then of course had to announce spending cuts to try to get back in control of its runaway finances.
"I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody." - James Carville