Plain English for non-economists – what happens in a government bond sell off?

 In the last week, the mutual fund which was largest holder of short-term US government debt sold off all their holdings of US government bonds that matured in the next 90 days. So what happens next?

From Wikipedia
From Wikipedia

I need to explain a bit of arithmetic here, but please bear with me. The arithmetic will only take a minute.  A bond is a tradable IOU. Suppose I wanted to sell you an IOU that said I would pay you $100 in a year’s time. If the interest rate were 2 per cent, you’d be prepared to pay $98.04 cents for it. You get this by dividing $100 by 1.02 (1+ the interest rate as a decimal.) Why? Because if you put $98.04 in the bank at 2 per cent, you’d get $100 at the end of the year.  Suppose interest rates were 5 per cent.. you’d pay $95.23 for it. ($100/1.05)  Why? Because if you put $95.23 in the bank for a year at 5 per cent, you’d get $100 at the end of the year. If it were 7 per cent, you’d only pay $93.46 (100/1.07).

Do you see the pattern? As the interest rate goes up, the resale price of a bond goes down. Saying the bond price went down is the same thing as saying the interest rate went up. Investors  are beginning to dump US government IOUs that mature in the next 90 days, because they are afraid the US government won’t be able to pay up on time. Once a few funds begin to do this, others will be forced to follow. Investment markets work as herds. If everybody is dumping something, and you don’t, you get stuck with an asset that’s worth less than what others are holding. So if the price of US government securities fall, interest rates go up. It’s the same thing.

The next problem is how banks price interest rates on loans. They take what they regard as the “risk free interest rate”, and then add margins onto it for riskier loans. For as long as anyone can remember, US banks have regarded US government bonds as the risk free asset.

If there is a default on bond payments, what is the risk free rate? It’s very dangeerous territory, because it only happened before in 1979 (see below) and circumstances were very different then. And what would  financial institutions hold for short-term debt, if they think US bonds are unsafe? British, German or Swiss IOUs? Nobody knows.  Many personal investors have bonds in their pension funds. Many banks need short-term instruments for liquidity. A sell-off could begin to snowball, affecting bonds beyond the 90 day papers that had been sold off so far, reducing the value of other, longer-term bonds. If that happens, a lot of damage will have been done. So know you know. If a solution isn’t found, a lot of people and banks will be deep in doggy-do.

There was one incident, during the  Carter Presidency, where the US was up against its debt ceiling, and while a deal was done at the minute to raise the ceiling, the US Treasury was a late in making interest payments. Not everything was computerized as well back then. Investors knew the payments would be made, because the deal had been struck, but nevertheless, interest rates went up by 0.5 per cent, and didn’t go down again immediately the payments were made. That meant an increase in on-going interest costs and some institutions sued the US govt over the back interest.

I’m reproducing a description here from a website that gives the details of the 1979 incident, but you’d need to scroll down a long way to find these paragraphs, so I’ll reprint them here. The reference is to April 1979, when there was a fight over the debt ceiling, and a deal was made but interest was paid late.

In April of 1979, Congress failed to legislate to reach a deal in time, and the Government hit the debt ceiling. Without the ability to borrow more it had to decide who not to pay. It could ‘close down the government’ and stop paying employees or suppliers, or it could stop paying interest and maturing principal on its debts – Treasury bills, notes and bonds. It chose the latter.

In the 1979 defaults, the US Government didn’t treat all its creditors equally. Most Treasury bills, notes and bonds are held by banks and other financial institutions like insurance companies and pension funds, with a small minority held by individuals. In 1979, the Government chose to repay the main institutional creditors in full, out of fear of triggering a banking crisis, but chose to default on 6,000 individual investors.

On 26 April 1979, the US Treasury defaulted on $41 million of maturing Treasury bills. They were paid 20 days late on Thursday 17 May 1979 after the Government found some money. Then again on 3 May 1979, Treasury defaulted on another $40 million. These were also paid 14 days late. Then again on 10 May 1979, Treasury defaulted on yet another $40 million of maturing T-bills. These were also paid on 17 May.

Treasury refused investors’ demands to reimburse the $325,000 in lost interest on the late days and so investors were forced to sue the US government in a class action (Claire G. Burton v. United States, US District Court, Central District, California, D 79, 1818LTL (Gx)). Unfortunately the Court threw out the investors’ claim by relying on a 1937 Supreme Court ruling that, “interest does not run upon claims against the Government even though there has been a default in the payment of principal”. (Smyth v. United States, 302 U.S. 329, 1937). It came as a shock for Americans to discover that not only had the Government defaulted on its debts, but there was a decades old judicial precedent establishing that it didn’t legally owe interest when it failed to pay on time! When the money market opened on Friday 27 April 1979, the day after the first default, T-bill yields spiked up by 50 basis points  [Note by RS: 50 basis points mean half a percent.] and this default premium on US T-Bills remained even after the default was rectified the next month. This demonstrates that the US Government has indeed defaulted on its debt (at least temporarily), and that US T-bills are not ‘risk-free’, but are prone to a credit default premium in their pricing.  

 Quote from  http://cuffelinks.com.au/us-government-previously-defaulted-risk-free/

So, a delay of about 3 weeks in paying interest on bonds previously caused a rise of half a percent in the government’s borrowing costs. It seems plausible that a longer delay would cause a bigger rise in interest costs. Hopefully we don’t find out the answer to that.

Finally, half a percent might not sound like much. But the US has about $17 trilliion of bonds outstanding. Unless the budget moves back to surplus and the government can start buying it’s own bonds back, each of those bonds has to be replaced by a new one as it falls due. Half a percent of 17 trillion would be about 85 billion in extra interest, spread out over the life of the existing bonds.  it doesn’t hit all at once but that’s a lot of cash.

So, are you affected? Do you hold government bonds in your pension fund or 401k? What do you intend to do? And what do you think about the current situation? Does it bother you?

 

My novel Fire Damage, an action thriller, is available on Amazon Kindle, here. The novel is based on the Japanese religious cult Aum Shinrikyo, which released Sarin nerve gas in the Tokyo subway system in the 1990s. If you don’t have a Kindle, you can download the app to read it on your computer or phone from here. A paperback version is available here. It’s also available as a Kindle on Amazon UK .    twitter: @Richard_A_Snow
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