Bond Vigilantes
Research for Online Investors

by John Dalt

2/26/10

Galtstock concentrates on equities for investors, paying attention to the debt of the companies we invest in. We also comment often on the debt problems of the U.S. and other countries such as Greece, this is called sovereign debt.

Many investors invest in bonds, or debt from corporations as a fixed asset that pays interest over a set period of time before returning the principal.

Bonds are a debt of the issuer, payable before the owner gets any return on their equity.  In the business world, this means bondholders get paid before shareholders.  In the world of governments, it means catastrophe for the citizens when sovereign debt of their country looses the confidence of investors, or the amount of bonds for sale is greater than demand.  When this happens interest rates increase to attract buyers, raising the cost for other issuers if they are to compete.  This is when commentators use the term ‘bond vigilantes.’

When investors shun a country’s debt because of concern over the return of their money, interest rates must increase to make the offering attractive.  Bond investors are attracted to safe returns like flies to honey, equally safe bonds are differentiated by the interest rate paid (yield).

We wrote Wednesday about the difference in interest rates offered by Greek, German and U.S. bonds.  Greek ten-year bonds currently yield 6.57%, while German 10-year bunds yield 3.13%  U.S. ten year bonds presently yield 3.695%  The Bank of England (BOE) bought 90% of the country’s debt last year, this has held their interest rates lower.

Imagine, how high the market would force interest rates, if the government wasn’t buying 90% of the bonds for sale?  The BOE has signaled they would slow the purchase of government debt; the spread (difference in rates) went up over one percent higher than German bunds to 4.25%

The European Central Bank (ECB) has been more discrete in supporting the euro.  The ECB has loaned money to euro zone banks at 1% interest, which they in turn used to buy sovereign debt from euro zone nations.  Euro zone countries need to borrow an estimated 2.2 trillion Euros in 2010 to finance deficits and roll-over existing debt.  This represents 19% of the euro zone country’s GDP.  France must borrow 454 billion Euros, Italy 393 billion, and Germany 386 billion Euros respectively.

European banks owe the ECB 442 billion Euros by July 1, 2010.  If the ECB will not extend these ‘quantitative easing’ loans the banks will be forced to sell euro denominated bonds to raise money to pay back their loans.  442 billion represents more than half of the quantitative easing the ECB has pumped into the economies of the euro zone countries.

This could cause a spike in interest rates in euro denominated bonds, putting more pressure on Greek bonds that are already priced 300 basis points (3%) over German bunds.

The U.S. Federal Reserve’s purchase of treasuries is scheduled to end in 30 days.  Will they continue their policy of quantitative easing by copying the ECB’s policy of low interest rate loans to favored banks, which then use the funds to buy treasuries? This may be the next back door the Fed use to continue support the spending in Washington.

There is a perfect storm of tight credit on the horizon.  Government deficit spending in the developed world to maintain entitlement programs and failed attempts to prop up employment is the 300 pound gorilla that will crowd out corporate borrowers at competitive rates.  Government’s attempts to manage economies always end in failure.

Hello to the misery index from the 1970’s, high inflation, high unemployment and high interest rates.

We do not recommend bonds, preferring to concentrate on equities.  Why do we worry about high interest rates?  HIGH INTEREST RATES HURT EQUITIES.  Stock prices are a reflection of corporate profits.  Companies that borrow money will see their borrowing costs increase significantly, reducing the profits that can be booked from the leverage of their balance sheet.

Subscriber R.L. sent these pictures with a derisive comment about the need for technology to address grade school students.

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'You don't need God anymore, you have us Democrats.' ----Nancy Pelosi (Quoted 2006)

Ok, but does God need a teleprompter?

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions.  It may contain errors and you should not make investment decisions based solely on what you believe you have read here.  Do your own research, it is your money.  If you lose it, it is your responsibility, not ours or your grandmothers!  The editor may or may not have a position in any securities discussed.  The editor may have held a position in a security earlier, or in the future.

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