What is the bond market and how does it work?

We’re told that any government trying to do something as unhinged as, oh I don’t know, ending homelessness or preventing juvenile crime will offend the mighty bond markets who shall rain down fire and brimstone reminiscent of a scene from Genesis.

If we want to avoid the wrath of god, we have therefore to live in country with crumbling infrastructure, overpriced utilities, and stressed public services.

What is the bond market?

But what is the bond market and how does it work? It has nothing to do with who replaces Daniel Craig.

First of all, government finances are not like personal finances, so any analogies are misleading.  Governments don’t sell their labour for payment. Citizens can’t demand a contribution to collective projects and imprison you if you refuse. Neither does government borrowing resemble personal borrowing.

The main way the UK government borrows is by selling bonds, also known as gilts, because in paper form they had gold coloured edges.

It works like this. The Bank of England (BoE) sells a bond, on behalf of the government, valued at £100. An investor buys it, paying them £100. Obviously, investors buy them in huge numbers, thousands and millions at a time.

A bond has an interest rate and an expiry date. So you might buy a ten year bond with a 4% interest rate. That means if you buy it in December 2025 for £100, then in December 2035 the bond matures, which means the BoE cancels the bond, and pays whoever owns it at the time the original purchase price of £100.

Changeable value

By then, as a result of inflation, the £100 will buy less than it will today. But every year, the BoE will also pay the interest on the bond known as the ‘coupon’. In our example, it will pay 4% of the £100, or £4 per year. It pays in two instalments of £2, in six monthly intervals, to whoever owns the bond at the time.

The interest rate on a bond does not change once it has been issued, nor does its redemption price. So even if BoE interest rates later change, the amount of interest paid on existing bonds remains the same. It’s a bit like having a fixed-rate interest-only mortgage.

Bonds are issued with different time periods. Some are ultra-short one year bonds, some 50 year bonds, and everything in between.

Let’s look at some numbers. There are £444bn of gilts maturing between now and December 2028, with interest rates varying from 0.125% to 6%. £432bn mature from 2029 to 2032. £525bn from 2033 to 2040, and £715bn from 2041 to 2073.

You can download the figures yourself from the Government’s Debt Management Office website.

So what?

So why do we hear about bond markets? Because traders buy and sell them. Some for sound financial management reasons, and some for speculation – gambling to make money.

Bonds are known as near-cash assets. Rather than keep huge cash reserves that earn meagre interest, big companies and financial institutions store their cash in bonds.

Because the UK government can’t go bust – it can literally print money if it wants to – bonds are safe, and pay interest. To make sure they can pay their policy holders, UK pension funds are required by law to keep a large chunk of their assets as cash or near assets, estimated at £1.4tn in bonds. That’s £1,400bn.

Ready market

So there is a ready market for bonds. And if the government didn’t issue bonds, our pensions would struggle to find somewhere as safe to park the money we have paid in.

What happens when they are traded? Let’s use a simplified example. Whoever owns the bond gets the interest when it’s due, and gets the original purchase price when it matures.

Suppose you’re in the market for some bonds. You could buy new government bonds that pay 4% interest. But why would you, if there are old bonds in existence paying 6%? Well, because anyone with 6% bonds will charge a higher price.

Likewise, there are billions of pounds in old bonds that were issued at 0.125% interest. No one is going to pay £100 for a bond that pays 12.5p a year when they can buy a new £100 bond that pays £4 a year.

So the prices are adjusted by traders. But regardless of the price agreed between them, the government pays only the interest that was set when it was issued.

Can a government issue unlimited bonds? In theory, yes. But there’s only so much cash looking for a home in tradable bonds at a given time.

If the government wants to sell more than the immediate demand, it may have to raise interest rates, to attract investment. That could make older bonds less valuable, if the new ones pay more interest.

What can go wrong?

This is part of the reason for the Liz Truss mini-budget catastrophe. When Kwasi Kwarteng announced unexpected tax cuts on 23 September 2022, bond traders concluded there would soon be extra bonds issued soon, at higher interest rates.

So the bonds in circulation weren’t as valuable. The interest rate on bonds already issued didn’t change, but they became less valuable. The near-cash assets owned by pension funds were suddenly less valuable.

The real incompetence of the Truss mini-budget was they did not seem to notice the BoE announcing the sell-off of £80bn of bonds on the 22 September 2022 as part of its quantitative tightening programme.

The market was flooded, driving down the value of pension assets, and creating knock-on effects. That’s a whole other article.

Quantitative tightening

It’s worth noting that the BoE owns around 30% of all UK gilts. It bought them using quantitative easing after the 2008 crash, and more during Covid. They simply created the money electronically, and bought bonds held by banks.

In other words, they created £895bn by the press of a keyboard, because it was deemed politically and economically wise to do so at the time.

Quantitative tightening is the process of selling those bonds back into the market. It creates more supply, lowering prices, and increasing the interest that needs to be paid on new bonds.

The Office of Budget Responsibility predicts a loss to the public purse of around £165bn. Or put another way, a profit of £165bn for people who are already very rich.

For example, the BoE bought some 2061 0.5% Gilts for £101 each. It sold them for £28. It will now have to pay the interest, and eventually the redemption price, to the owners. If it just kept them it would pay that money to itself.

No other country is pursuing this policy.

Debt

The UK government has other debts. There are other bonds which operate much the same way, like index linked bonds and Green Bonds.

There’s approximately £231bn in National Savings. If you have any Premium Bonds, that’s a debt the government owes you.

The BoE holds around £786bn in commercial bank reserves – Barclays, HSBC, etc. That’s a very different kind of debt, but the BoE does pay interest on it. This is costing the country, at current rates, £31bn a year – enough for 150,000 high quality homes.

The government could just tell the BoE not to pay this, or to pay less. It never used to – banks were paid no interest by the BoE before May 2006. The four big banks made £46bn in profit last year.

In fact, if the government did build 150,000 high-quality homes for social rent it would recoup billions immediately from taxing the extra wages of workers employed to build them, all the VAT on their expenditure, and have a rent-paying asset for decades afterwards. Never mind the savings made from ending the social costs of homelessness.

What are the alternatives?

Okay, so that’s how bonds work. How does this affect the choices our government can make? That needs a whole other article. But there are four points to take away.

1. Markets do not control government policy. Bond traders are only interested in making a profit. They respond to supply and demand. A government that invested in real wealth generation would create a demand for bonds, lowering interest rates.
2. The BoE has the power to set interest rates. We should stop paying billions on private banks’ central bank reserves that boost private profits.
3. Our government has placed itself in a straight jacket of its own making. Governments have lots of options. They can borrow, yes. The government could issue special bonds to capitalise regional investment banks, or take utilities into public ownership, making them available exclusively to private citizens and pension funds. They can create money. They can also tax the rich, to make sure money is diverted away from speculation and into something socially useful. Put it this way, if there was a war, would they say, “We can’t buy any weapons, our fiscal rules won’t allow it.”?
4. Most importantly, four. Anything that is productive, that helps the economy, that makes people more skilled or less ill, that improves transport or productivity, is a good investment.

Real wealth is skilled people doing useful work. Fix that, and the money will follow the investments.

In fact, there is no sensible reason not to do this. Unless you want your mates to make huge profits. And look forward to your £90k seat on a board for half a day’s work a month after you’ve left government.

Featured image via the Canary