By Nicholas M. Dockerty
Bonds, government bonds. They’ve been in the media spotlight recently as the eurozone has struggled to cap its debt crisis. First Greece and then Ireland, who will be next?
But what are government bonds and why are they so important to a country’s economy?
Bonds are one of the main ways a government can raise capital. The government essentially borrows money from a lender – be it a bank or an individual investor – by selling them securities called bonds. The borrower, that is the government, then agrees to repay the loan by a fixed date and makes any interest payments along the way.
Government bonds are seen as appealing long-term investments by investors, especially in times of low interest rates as the lender is guaranteed a fixed interest rate and will get back their original outlay at the end of the specified period. Another benefit of bonds is that they can be sold for profit on the financial markets.
However, there are risks. If interest rates suddenly rise then the value of a bond that is fixed at a lower rate will decline in the market. Also, like any loan, if the borrower, in this case the government, gets into financial difficulty and doubt arises whether they can afford to pay back the loan then this too can drive the value of bonds down on the market.
If a lender receives a government bond worth £200 with a fixed yield of 5% and the market value of the bond drops to £100 then the fixed interest payment remains at 5% but the yield is greater now at 10%.
When a government wants to raise new money by issuing bonds it must do so at the interest rate dictated by the current yield of bonds in the market. Therefore, the bond markets determine the cost at which a government can borrow.
And that’s what makes bond prices important to a country’s economy.
To illustrate this with a recent example. After the Irish government signed off on the EU’s 85 billion euro rescue package on 29 November 2010 the cost of borrowing for ten years for the Greek government was 11.9%; Portugal 7%; Spain 5.2% and 4.6% for Italy. Contrast these figures with that of their eurozone companion Germany, whose cost of borrowing over ten years was a touch under 2.7%.
It was these figures that made sure global investor confidence would remain low in the aftermath of the Irish rescue deal. Indeed, would another sovereign debt crisis signal the end of the eurozone? Or, bring about full fiscal union?
About the Author
Trading CFDs is becoming increasingly popular because of the range of markets you can choose to trade. From bonds to interest rates and more you can discover more at http://www.igmarkets.co.uk. IG Markets is the UK’s number one CFD provider.
