Scottish-born economist - Angus Deaton - recently published his new book - An Immigrant Economist…
Many readers have E-mailed me asking me to explain yields on bonds and sovereign credit ratings. There has been press coverage in recent days that following the downgrading of Greece, sovereign debt in the UK, France, and Spain will be downgraded unless severe “fiscal consolidation” is begun. All these places are suffering very depressed domestic conditions with high unemployment, falling per capita incomes and civil unrest looming. The last thing these nations need is for their national governments to be raising taxes and cutting spending. But the financial press are using the threats from these nefarious and undemocratic credit rating agencies to berate governments to do just that. Undermine the welfare of their citizens. Further, judging from the E-mails I have received on this issue there appears to be a lot of uncertainty in the minds of interested people about what all this means. Here is a little introduction which I hope helps.
The leading line in a Financial Times article on May 21, 2009, read (Source)
Oh boy, is Gordon Brown in trouble.
I thought he must have caught a bad cold or a tooth filling had fallen out. So I read on. I was wrong – it was more trivial than any of those maladies.
It turns out that a credit ratings agency had decided that Britain was in big trouble because its government was using the fiscal powers invested in it legally, by dint of the democratic process that enjoys a fine tradition in that land, to address an economic calamity of some significant dimension. These agencies at best walk the line between the criminal world and the seedier side of life.
The FT article said:
The parliamentary expenses scandal in Britain may have distracted the public’s gaze from the dire state of the local economy, but rating agency Standard & Poor’s has now guaranteed its return to the front pages.
So what happened was – to refresh our memories – on May 21, 2009 the ratings agency Standard & Poor’s attempted to impose its sense of self importance on the world stage once again by revising its “outlook” for UK sovereign debt from stable to negative because it believed the “government debt that would be hard to rein in and political uncertainty about the policy response with an election looming”. This means that it is rating
Standard & Poor’s went on:
The negative outlook reflects Standard & Poor’s view that, in light of the challenges to strengthen the tax base and contain public expenditures, the U.K. government debt burden could approach 100% of GDP by 2013 and remain near that level thereafter.
The press reaction at the time was near hysterical – with some journalists describing the development as a “Humiliation for UK” (Source). I wonder if we had done a poll the following day of the millions of unemployed Britains about whether they were humiliated and if so, why – we would have ticked the S&P threat very highly?
Anyway, what does it mean? A sovereign debt rating is an assessment by a credit rating agency (Standard & Poor’s, Moody’s or Fitch) that the government will default on its loans. Yes, it is a puerile as that.
Standard & Poor’s claim they use many factors in assessing the sovereign debt rating such as economic growth, political stability, financial reserves, inflation and exchange rate policies.
You will note they do not include the sovereignty of the country in the sense of whether it issues its own currency or not. More about which later.
S&P did not actually downgrade the AAA credit rating for the UK – they just “changed their outlook and said that there was a 33 per cent chance that the credit rating would be cut.
What it means is that under certain conditions, investors use the ratings (if they are stupid) as an indicator of default risk which means that when bonds are issued into the primary market they will seek larger discounts on the price to adjust the yield for the nominal coupon rate and the risk. Higher risk – higher the discount.
A compliant government (one that accepts the international criminal bullying of the ratings agencies) will react like a lapdog, put the interests of their citizens second, and start to introduce discretionary contractions in their net spending (either/or raising taxes or cutting spending).
In this regard, when the May warning was given the UK government, the relevant Standard & Poor’s credit analyst said that:
The rating could be lowered if we conclude that, following the election, the next government’s fiscal consolidation plans are unlikely to put the U.K. debt burden on a secure downward trajectory over the medium term … Conversely, the outlook could be revised back to stable if comprehensive measures are implemented to place the public finances on a sustainable footing, or if fiscal outturns are more benign than we currently anticipate.
Note there is no mention of the Government succeeding in reducing job losses or providing quality schooling or first-class health care. It is as mindless as it gets.
To understand this a bit further some appreciation of how bonds are issued and priced is helpful. I have received a lot of E-mails about this.
While I am most familiar with the Australian institutional structure, the following developments are not dissimilar to the way bond issuance (in primary markets) is organised elsewhere.
A primary market is the institutional machinery via which the government sells debt to “raise funds”. In a modern monetary system with flexible exchange rates it is clear the government does not have to finance its spending so the “raise funds” hoopla is highly misleading as I have noted several times before. The fact that governments hang on to primary market issuance is ideological – “fear of fiscal excesses” rather than an intrinsic need.
So everytime I use words like “funding” you know it is in the context of their logic not the logic of modern monetary theory (MMT).
A secondary market is where existing financial assets are traded by interested parties. So the financial assets enter the monetary system via the primary market and are then available for trading in the secondary. The same structure applies to private share issues for example. The company raises funds via the primary issuance process then its shares are traded in secondary markets.
Clearly secondary market trading has no impact at all on the volume of financial assets in the system – it just shuffles the wealth between wealth-holders. In the context of public debt issuance – the transactions in the primary market are vertical (net financial assets are created or destroyed) and the secondary market transactions are all horizontal (no new financial assets are created). Please read my blog – Deficit spending 101 – Part 3 – for more discussion on this point.
Prior to 1979, treasury bonds were sold in Australia on a “periodic basis” in the primary market. People would go to a bank or stockbroker with $100 multiples to purchased a bond. The Loan Council (composed of the Prime Minister and the State Government premiers) would determine the annual government borrowing requirmements plus the maximum interest rate they woud pay and the allocation of borrowing between the federal and state spheres of government. The Loan Council was edged out of influence in the early 1980s and was terminated in 1993 which led to the creation of the Australian Office of Financial Management.
What happened was that the Loan Council would set the interest rates and then sell however many government bonds were demanded at that rate – the so-called “take-it-or-leave-it” approach.
If the “funding requirement” was not met then the net public spending would still flow and the treasury and central bank would have some accounting gymnastics – government issues debt to itself. Of-course, the central bank had no option but to engage in liquidity management operations in the secondary markets (selling their holdings of government debt) to ensure they drained excess reserves which may have destabilised their interest rate target. So the so-called “debt monetisation” was not really possible.
In April 1980, the government scrapped this system and introduced the so-called “tap system”. The government would set a yield and sell as much as it could. But it would be doing this continuously and adjusting the yields up or down to meet the market requirements and ensure that there were no discrepancies between net spending and bond sale revenue, which they thought off as “funding”.
The system came unstuck because it relied on the Treasury adjusting rates often which has some political implications they didn’t like, particularly approaching an election.
So in July 1982 the tap system was scrapped and the “auction” or “tender” system was introduced. This was the ultimate neo-liberal con job and took all discretion away from the elected government as to what it would pay on government debt issuance.
In this blog – Will we really pay higher interest rates? – I go into this period more fully and show that it was driven by the ideological calls for “fiscal discipline” and the growing influence of the credit rating agencies. Accordingly, all net spending had to be fully placed in the private market $-for-$. A purely voluntary constraint on the government and a waste of time.
The tender system required the federal treasurer to determine when a tender would be opened and the type of debt instrument to be issued. So they could determine the maturity (how long the bond would exist for), the coupon rate (the interest return on the bond) and the volume (how many bonds). I will show you the arithmetic soon.
The issue would then be put out for tender and the market then would determine the final price of the bonds issued. Imagine a $1000 bond had a coupon of 5 per cent, meaning that you would get $50 dollar per annum until the bond matured at which time you would get $1000 back.
Imagine that the market wanted a yield of 6 per cent to accomodate risk expectations. So for them the bond is unattractive and they would avoid it under the tap system. But under the tender or auction system they would put in a purchase bid lower than the $1000 to ensure they get the 6 per cent return they sought.
The mathematical formulae to compute the desired (lower) price is quite tricky and you can look it up in a finance book.
The general rule for fixed-income bonds is that when the prices rise, the yield falls and vice versa. Thus, the price of a bond can change in the market place according to interest rate fluctuations.
When interest rates rise, the price of previously issued bonds fall because they are less attractive in comparison to the newly issued bonds, which are offering a higher coupon rates (reflecting current interest rates).
When interest rates fall, the price of older bonds increase, becoming more attractive as newly issued bonds offer a lower coupon rate than the older higher coupon rated bonds.
So for new bond issues the Australian Office of Financial Management receives the tenders from the bond market traders. These will be ranked in terms of price (and implied yields desired) and a quantity requested in $ millions. The AOFM (which is really just part of treasury) sometimes sells some bonds to the central bank (RBA) for their open market operations (at the weighted average yield of the final tender).
The AOFM will then issue the bonds in highest price bid order until it raises the revenue it seeks. So the first bidder with the highest price (lowest yield) gets what they want (as long as it doesn’t exhaust the whole tender, which is not likely). Then the second bidder (higher yield) and so on.
In this way, if demand for the tender is low, the final yields will be higher and vice versa. There are a lot of myths peddled in the financial press about this. Rising yields may indicate a rising sense of risk (mostly from future inflation although sovereign credit ratings will influence this). But they may also indicated a recovering economy where people are more confidence investing in commercial paper (for higher returns) and so they demand less of the “risk free” government paper.
Yield concepts in fixed-income investments
To understand this better there are various concepts of bond yields that are used in the markets. The yield indicates the money that will be returned from the investment and is usually expressed in percentage terms. There are several concepts of yield that can be defined.
- Coupon or Nominal Yield – If a bond has a face value of $1,000 and is paying 8 per cent in interest, the coupon rate, then the nominal yield is 8 per cent. The investor will thus receive $80 per annum until maturity. The coupon yield remains constant throughout the life of the bond.
- Current Yield – Suppose you purchase an 8 per cent $1,000 bond for $800 in the secondary market. Irrespective of the price you pay, the bond entitles you to receive $80 per year in coupon payments. But unlike the previous example, the $80 payment per year until maturity represents a higher current yield than 8 per cent. The actual yield is $80/$800 = 10 per cent. So to compute current yield you simply divide the coupon by the price you paid for the bond. In general, if you buy the bond at a discount to face value, the current yield will be greater than the coupon yield, and if you buy at a premium then the current yield will be below the coupon yield.
- Yield-to-Maturity (YTM) – The current yield does not take into account the difference between purchase price of the bond and the principal payment at maturity. YTM takes into account that as well as earning interest, an investor can make a realised capital gain or loss by holding the bond until its maturity date. YTM is a measure of the investor’s true gain over the life of the bond and is the most accurate method of comparing bonds with different maturity dates and coupon values.
Example: – Assume you pay $800 for a $1,000 face value bond in the secondary market. The $200 discount on the face value is considered income or yield and must be included in the yield calculations. Assume that the 8 per cent $1,000 bond had 5 years left to maturity when it is bought for $800.
A comparison of three yield concepts gives:
- Coupon yield of 8 per cent ($80 income flow divided by $1,000 face value).
- Current yield of 10 per cent ($80 income flow divided by $800 discounted purchase price).
- YTM of 13.3 per cent ($120 divided by $900) – see below.
The computation of YTM is complex and can be simplified to the following rule of thumb:
YTM = (C + PD)/[0.5*(FV + P)]
where C is the coupon, PD is the prorated discount, FV is face value, and P is the purchase price. If the bond is trading at a premium, the numerator subtracts the prorated premium from the coupon.
In our example:
YTM = [80 + (200/5)]/[0.5*($1000 + $800)] = $120/$900 = 13.3 per cent.
When bond traders talk about yield they are usually referring to the YTM measure which is the only measure that asseses the effect of principal price, coupon rate, and time to maturity of a bond’s actual yield.
So do the credit rating agencies matter?
One view which is represented by this recent article – Credit rating agencies: the untouchable kings of finance – is that the sovereign credit ratings matter. The UK Telegraph article said:
There are any number of organisations and individuals who can be blamed for the credit crunch, but right up there at the top of any league table of culprits – along with the bankers, credit-drunk consumers, half- asleep policy makers and incompetent regulators – would have to be the credit rating agencies, those shadowy creatures that sit in judgment over the trillions of dollars of debt that swirl around the world’s money markets.
By assigning a top-notch, triple-A rating to many of the products that emerged from the boom in “structured finance”, the credit rating agencies played a pivotal role in fostering the mad dash into sub-prime mortgage lending which eventually triggered the worst banking crisis since the Great Depression.
I agree with this sentiment. The ratings agencies have admitted to US government enquiries recently that they took money in return for ratings that were not based on any fundamental assessments other than the cash they were being paid. They have lied about the risk of default in many corporate cases and then marked down debt when the game was up further destabilising the financial system.
They are thus criminal organisations. Please read my blog – Ratings agencies and higher interest rates – for more discussion on these points.
The UK Telegraph article notes that “the sub-prime meltdown is only the latest offence in a serial list of failings, be it the Latin American debt crisis of the 1980s, the Far Eastern crisis of the 1990s, Enron, and just about any other major default you can think of in recent history … In all cases, the rating agencies failed to see it coming. The charge list is damning, yet despite this latest, calamitous example of wrong-headedness, little is being done to reform the industry, curb its powers, or monitor its activities”.
But then the article says:
Discredited the agencies may be, but governments still hang on their every word and live in terror of a downgrade from the ranks of “teenage scribblers” they employ. The greater the perceived risk of sovereign default, the more that has to be paid for borrowings and the less there will be for spending on hospitals, schools and public services. Whole teams of British Treasury officials are employed to sweet talk the agencies into a fuller understanding of the security of our fiscal position.
So in this sense they are suggesting the the bond tender system in the UK will be compromised by the ratings agencies threats and assessments so that the purchasers will be prepared to pay lower prices for the bonds to get the higher yields to compensate for the higher perceived risk. There are also claims that eventually this closes government down because the arithmetic turns against them – they get lower prices, have to issue ever more volumes of debt (because they impose stupid voluntary constraints on themselves), the ratings drop further, etc.
The other claim represented in the previous quote is that the higher yields compromise the ability of the government to spend elsewhere (hospitals etc). That claim is only true if the government sets an artificial limit on its budget or is already overseeing an economy which is at full capacity utilisation (so no more non-inflationary nominal aggregate spending can be made). The UK is so far from the latter but, probably, is close to the former because it lacks adequate national leadership.
In the past week, Moody’s has also been threatening the British Government following the downgrading of Greece. The other agency Fitch also said yesterday that Britain (along with France and Spain) had to “articulate more credible and stronger fiscal consolidation during the course of 2010 to underpin confidence in the sustainability of public finances”.
As the Guardian reports today (Source):
Failure to do so, the ratings agency added, would greatly increase the chances of a debt downgrade, which would increase the cost of servicing the national debt.
Note once again the absurdity of comparing the fiscal capacity of a sovereign nation like Britain with non-sovereign Eurosystem countries. There is no legitimate comparison that can be made and this point shows that the ratings agencies do not work from a comprehension of the inherent characteristics of the monetary system.
In fact, Britain has defaulted once in its history – during the 1930s – when it was still caught up in a gold standard. The Bank of England overseeing an economy ravaged by the Great Depression defaulted on gold payments in September, 1931. The circumstances of that default are not remotely relevant today. There is no gold standard, the sterling floats.
But the problem is that these assessments do create instability in the financial and foreign exchange markets that can damage vulnerable nations.
The other problem is that governments listen to the agencies, in the same way they listen to the IMF, and put the interests of these undemocratic and crooked agencies ahead of their own national interests.
The Bank of England sets interest rates not the bond markets, although the latter may impact on the prices and yields of longer-term investent assets.
But in general, as the Bank of Japan showed in the period from the mid-1990s onwards that they can keep interest rates very low (zero) and issue as much government debt as they wanted even in the face of consistent credit rating agency downgrades (see below).
So if a government stands up to the agencies their impact is likely to be minimal.
Further the government has it within their capacity to stop issuing debt whenever they want to change the regulations/laws that dictate these absurd voluntary constraints. In that way, the sovereign debt bureaus within the credit agencies would be able to free their workers to do something productive – perhaps work in the welfare system or wherever.
At present they do nothing productive and because governments kow-tow to their assessments they actually do real damage.
The UK is still mired in recession, Yesterday the Office for National Statistics revealed that the recession would continue into the 6th quarter – the longest in recorded British history.
Any thought that the government would start a process of “fiscal consolidation” (meaning raising taxes and/or cutting spending) in this environment amounts to a criminal act.
What is the risk of sovereign default?
There is virtually no risk despite the spurious claims made, for example, by Reinhart and Rogoff in their recent book “This time is different”. They pull out examples of sovereign defaults way back in history without any recognition that what happens in a modern monetary system with flexible exchange rates is not commensurate to previous monetary arrangements (gold standards, fixed exchange rates etc). Argentina in 2001 is also not a good example because they surrendered their currency sovereignty courtesy of the US exchange rate peg (currency board).
I thought this comment was interesting. It was mde by formers President of the Federal Reserve Bank of Dallas and former member of the Federal Open Market Committee, Bob McTeer who is described as having “free-market views” which “gave the Dallas Fed its reputation during his tenure as “The Free-Enterprise Fed”” (Source). McTeer says:
It may just be me, but aren’t the credit rating agencies supposed to be rating credit?
Yesterday, we saw a sharp market reaction when one of the rating agencies that gave AAA ratings to mortgage-backed securities larded with subprime loans called into question the credit worthiness of Britain. As is the case with the United States and the Federal Reserve, Britain and its Bank of England have the ability to create new money if necessary to pay off its debt at maturity. There is no sovereign credit risk. There is no need for credit rating agencies to opine on the credit worthiness of sovereign debt.
Sovereign debt is subject to interest rate risk. When interest rates in general rise, outstanding bonds, sovereign and non-sovereign, will decline in price, the extent depending on how close they are to maturity.
Sovereign debt is also subject to inflation risk. Holders of the debt are harmed if inflation outpaces their expectations when they purchased the debt.
When Standard & Poor questions British bonds, they must be making a judgment about some risk other than credit risk. Given time, investors will learn to take such questions with a grain of salt and not overreact. Meanwhile, haven’t they done enough harm for this cycle?
The recent history of Japan is also interesting. I discuss their sovereign debt run-ins with the credit rating agencies in this blog – Ratings agencies and higher interest rates and I won’t repeat the analysis.
In November 1998, the day after the Japanese Government announced a large-scale fiscal stimulus to its ailing economy, Moody’s made the first of a series of downgradings of the Japanese Government’s yen-denominated bonds, by taking the Aaa (triple A) rating away. By December 2001, they further downgraded Japanese sovereign debt to Aa3 from Aa2. Then on May 31, 2002, they cut Japan’s long-term credit rating by a further two grades to A2, or below that given to Botswana, Chile and Hungary.
In a statement at the time, Moody’s said that its decision “reflects the conclusion that the Japanese government’s current and anticipated economic policies will be insufficient to prevent continued deterioration in Japan’s domestic debt position … Japan’s general government indebtedness, however measured, will approach levels unprecedented in the postwar era in the developed world, and as such Japan will be entering ‘uncharted territory’.”
The Japanese government (Finance Minister) responsed very sensibly:”They’re doing it for business. Just because they do such things we won’t change our policies … The market doesn’t seem to be paying attention.”
Indeed, the Government continued to have no problems finding buyers for their debt, which is all yen-denominated and sold mainly to domestic investors. It also definitely helped Japan that they had such a strong domestic market for bonds.
In the New York Times the logic of the rating was questioned:
How … could a country that receives foreign aid from Japan have a better rating than Japan itself? Japan, with an economy almost 1,000 times the size of Botswana’s, has the world’s largest foreign reserves, $446 billion; the world’s largest domestic savings, $11.4 trillion; and about $1 trillion in overseas investments. And 95 percent of the debt is held by Japanese people.
The Telegraph article said of Japan:
Bizarrely, securities backed by mortgages sold to people without the income to service the debt they were taking on were being judged a better credit risk than the sovereign government of Japan, with the ability in extremis both to raise taxes and print money to avoid a default.
Rating sovereign debt according to default risk is nonsensical. While Japan’s economy was struggling at the time, the default risk on yen-denominated sovereign debt was nil given that the yen is a floating exchange rate.
The real question that I always ask is why government’s allow these undemocratic criminal organisations to exist. They can just outlaw them. This would force the corporate players to create better ways of informing the markets about their risk characteristics and leave governments alone to do what they are democratically elected to do – advance public purpose.
Further. as part of my preferred financial market reforms I would render illegal a whole swag of derivative assets which would lessen the problem of pricing risk.
It is time to wean the private financial markets off these agencies. The best way would be to declare them illegal.
The last thing that a sovereign government should be doing right now is cutting back on its fiscal stimulus.
Meanwhile … Britain sets about undermining its future
This Times article – Huge cash cuts to hit teaching at universities – reports that:
Universities will have to make severe cuts after Lord Mandelson abruptly slashed teaching budgets by millions of pounds yesterday … Departments are expected to close, degree courses will be scrapped and students will have to pay higher fees … The cuts mean that funding per student has fallen in real terms for the first time in ten years.
So the British Government which thinks it has “run out of money but it hasn’t” don’t want a better future for the children of their land.
But then I suppose you would want to cut back on educational spending given that “unemployment in the recession is rising fastest among 18-24-year-olds who have degrees … [and] … one in five unemployed 18-24-year-olds had a degree” in the UK (Source).