I have been in demand by MPs and the media to explain how the bond markets work. As daily we have front page news of movements in the price of bonds and therefore in the longer term rate of interest, let me have another go.
If a government issues some debt to pay some of its bills, it promises to make a regular fixed payment of interest on the debt. So, let us say it sells Ā£10,000Ā of debt at 1% interestĀ to a bond buyer, as part of a much bigger issue . For ease of calculation let’s say it never promises to repay – there is some debt like that. Such irredeemable debts are similar in the way they behave to long dated debt, 50-70 year debt which is repaid at the end of the stated time. The UK has been issuing some 50-70 year paper which is a debt that only repays a long time hence.
If the Central Bank then decides to put interest rates up to 2% the owner of the 1% paper is being short changed but their interest receipts stay the same. If they want to sell their bit of the debt on as they can do in the bond market, they will find that the price of it hasĀ halved. The buyer of the Ā£10,000 bond will only pay Ā£5000, as he wants a 2% rate and the Ā£100 guaranteed interest payment stays the same, to give him 2% (Ā£100 divided by Ā£5000).
We have just lived through a period when the Bank of England has bought up Ā£875bn worth of bonds, at ever crazier prices, taking the interest rate on them down to tiny amounts. Now they wish to drive interest rates up. They can do so by having the sole power to set the official short term rate of Bank rate which we know, currently now up to 2.25%. They can also do so by manipulating the price of bonds.
As the largest buyer of government bonds in recent years theirĀ decision at the end of last year to stop buying them pushed the market down substantially and therefore longer term rates of interest up. On the Thursday before the Kwarteng Statement the Bank announced it would go further, seeking to reduce its holdings of government bonds by a chunky Ā£80bn. The thought of the Bank selling bonds led to price falls as the Bank must have wanted. To get the longer term interest rates up they need to get the price of bonds down.
By the following Wednesday the bond market had fallen a lot. The decline was bigger in the UK than in other countries where Central Banks were also forcing rates up, mainly because in the UK a lot of pension funds had bought into funds that let them indirectly own more bonds than they had to fully pay for. As bonds fell they had to put up more money for these geared positions, forcing yet more sales to raise money for the calls. The ECB is not threatening to sell some of its huge holdings of bonds as it is worried what thatĀ might do to their bond markets.
The Bank then decided this had gone too far and flipped from being a seller to being a buyer again of bonds to try to stabilise the prices. The Bank’s own pension fund has exposures to these vehicles. On Friday they changed again, ending buying with the possible threat of sales hanging over the market. It meant the market fell sharply after the announcement of a change of policy and Chancellor.
It is true some in the markets disliked the absence of forecasts and costings with the Chancellor’s measures, but as the gyrations in the week following show the main driver of bonds falling and then recovering was Bank of England action. The Bank can have a big influence on whether mortgage rates go up or go down. The commentary which sees the whole thing as a response to the mini budget is simply wrong. I have always wanted the government to set out costings and present spending and tax at the same time as is traditional.
October 17, 2022
Isn’t it time that Bailey was replaced by some competent person? Why was the Green zealot Carney headhunted and then did nothing to correct near zero interest while plotting the end of carbon fuels? The Bank is now fully on with ESG and Diversity Inclusion and E whatever that is. There needs to be a clear out.
October 17, 2022
+1. The man is grossly incompetent as we saw with the FSAās one size for all regardless of credit risk rip off overdrafts. Unfit to run his own piggy bank.
JR is right on this.
āThe commentary which sees the whole thing as a response to the mini budget is simply wrong. I have always wanted the government to set out costings and present spending and tax at the same time as is traditional.ā
Indeed Osborne, Hammond and Sunak build a dire & unstable economic tower based to tax, borrow, print and waste. The mini budget was just the tiny last failure that brought the whole rickety tower down. Next PM after general election according to the betting odds roughly Starmer 90%, Boris 10% Sunak 9% Truss 1% what can be done to avoid disaster of Starmer/SNP and the prob. break up of the UK?
October 17, 2022
We have not had a competent person head up the BoE for many years Eddie George perhaps? Nor a competent Chancellor for even longer still.
October 17, 2022
JR,
What a tragedy that you are sidelined answering questions while a dummy is in no.11. Hunt was in govt when it repeatedly failed to balance structural deficit, he was there to achieve 70 year high taxes, your manifesto says no tax rises- so he puts them up in stark contrast, failed to sort out health tourism, every position and term in govt led to failure. So who chose him because I do not think it was Truss.
Hunt gave a good tax rise statement to commons which any labour govt would be proud. There is no point to your party and govt. None.
October 17, 2022
To follow the example – if someone buys a long dated bond that pays 1% and subsequently finds they could get 2% on their money elsewhere – and, as a result the bond has dropped in value by half, why on earth would they sell the bond? Surely buying a long dated bond is a decision you stick with.
It seems an odd decision to me. Why would anyone buy a long dated bond at 1%. Youāre guaranteed that your money in 59 years time will be worthless due to inflation.
October 18, 2022
which is why it is good there is a liquid market. The current price being effectively based on the yield expressed in current terms. The point being that government bonds are considered to be the lowest risk, so yields are the important determinant of price.
October 18, 2022
The rules for pension funds require them to invest in gilts to cover annuities for pensions in payment. Under ZIRP, gilts holdings initially went up in value, because the existing gilts were paying higher coupons. Permitted financial engineering allowed pension funds to get a higher apparent yield in exchange for being at risk should interest rates rise. When a market starts falling your choice is sell today before it goes down further, or wait until values are so low that your fund is insolvent. It becomes a self reinforcing cycle. Where there are derivatives (interest rate swaps that pay extra while bank rate is low, but require payments when interest rates are higher), these are valued at current market rates. Where they are loss making, it is necessary to provide collateral to cover the loss. Raising cash to fund the collateral also leads to sales of gilts. These losses deplete the pension fund’s assets, and it becomes technically bankrupt.
October 18, 2022
Mike, do the newish workplace pensions (nest) etc. I wonder if they are forcefully told they have to have a holding of them? It’s only something compulsorily taken from people (with an opt-out granted, but that’s too much trouble for workers and they think mistakenly that their 8% contribution will buy them something like a pension in the public sector hahaha).
October 17, 2022
Yeah yeah we get it, a big boy did it and ran away, it’s NEVER the fault of the Conservative Party that’s been running this country for over 12 years
October 17, 2022
So again financial instruments (pension funds being permitted to part own bonds) leave the owners at risk of collapse. Why is this allowed, what is the benefit of owning parts of bonds? Why not just own fewer whole bonds?
In the same way that margin calls are proving problematic in the gas market margin calls have decimated the bond market.
October 18, 2022
I think that were you to make the effort to fully understand what was going on you would come to a different conclusion. Financial markets can be complex, but it is possible to understand the issues. Unfortunately many don’t bother, which is why mischievious, or perhaps ignorant journalists versed only in cut and paste can make waves.
October 18, 2022
Do point me in a direction that helps me fully understand Alastair.
Part owned bonds that need to be paid up when prices rise seems a recipe for disaster to me even if that disaster is likely to be some point much distant in the future. These are long term bonds, rates had to rise at some point.
October 18, 2022
Indeed. Timera have a chart that shows hedging capacity (represented by open interest) in the gas market halved between October last year and April (see chart 2)
https://timera-energy.com/eye-of-the-storm-lng-portfolio-stress-opportunities/
Price caps are no longer readily available in the market.
October 18, 2022
āEveryone has a plan until they get punched in the faceā
Great Jack Reacher quote.
October 17, 2022
Thank you for that explanation Sir John. I now understand a bit more of what has been going on.
October 17, 2022
Is this an example of a dead cat bounce?
October 17, 2022
Now we are getting to the real reason why markets collapsed, not the puny tax changes that were announced.
Pray tell me why the taxpayer should bail out a Pension find that buys a 30-50 year bond with a return of just 1%, when even a clown knows that interest rates will go up way beyond that in the long term, thus reducing it’s value.
The City gamblers have failed us all yet again.
The real stupid decision by the Chancellor was to allow bonuses to increase for these people, that have nothing at risk themselves.
Amazing isn’t it John that you are one of the few politicians who has a wealth of experience within the Banking and Finance industry, together with real life experience of commerce and business, yet the Prime Minister offers the job of Chancellor to two people now with no experience whatsoever !
October 18, 2022
probably because they were “obliged to” by a government seeking to sell its paper. You will see many different clowns suggesting what pension funds should invest in, but unfortunately they are obliged to take government and regulators seriously.
October 19, 2022
Absolutely agree with your observations. Very well put.
October 17, 2022
Am I the only one who thinks Truss has done things backwards.
She sacks a Chancellor with whom she has had previous discussions, she then employs a new Chancellor who has policy thoughts different to her own (and who has no Treasury experience), she allows this new Chancellor to do the media rounds of interviews (giving his own opinion), and then invites him to Chequers for talks about how to proceed, but still thinks she is in charge ?
I am amazed. !
October 17, 2022
Many thanks Sir John, for a clear and concise explanation of how Bonds work.
Mrs T said “You can’t buck the Market”, but it does seem that you can nudge it one way or another…
October 17, 2022
Odd the likes of the BBC have failed to put the Gilts move in context of what the Bank of England were doing, or not doing, for their complacency about inflation has a pretty bad effect on the long end debt market , you almost feel we are only being given news that confirms their narrative.
October 18, 2022
it would be nice to think the BBC had people able to understand the issues, but experience tells us they rarely do.
October 17, 2022
Have a look at DMO Gilt retail prices. Particularly look at:
4 1/8% Treasury Gilt 2027 = 99.66 (Recent issue Friday 14th price)
1Ā¼% Treasury Gilt 2027 = 88.32 (Not 30.20 by JR’s Gilt arithmetic)
4Ā¼% Treasury Gilt 2027 = 101.06 (A little above par so market consensus Friday was circa 4.18%)
https://www.dmo.gov.uk/data/pdfdatareport?reportCode=D10B
The fastest way to put up Gilt prices and yields down is to stop issuing them. Issuing Gilts has nothing to do with funding government spending. There is no fiscal operational requirement for it in a fiat currency economy.
October 18, 2022
how do you think government raises money apart from by taxation?
October 18, 2022
It uses its own credit card that it issues to itself from the National Loans Fund, where It has unlimited credit and no repayment plan.
October 18, 2022
As gilts approach their redemption date the price reflects the value of both the coupon and the prospective gain or loss on redemption. So your 88 price would give a capital gain of 12/88 over 4-5 years (precise dates matter in the calculations) to add to the coupon payments. This gives the so called redemption yield, which you will find is quite similar to the gilts with coupons close to current market rates.
October 18, 2022
Convexity of bond prices and yields.
https://www.investopedia.com/terms/c/convexity.asp#:~:text=Convexity%20is%20a%20measure%20of%20the%20curvature%20in%20the%20relationship,said%20to%20have%20negative%20convexity.
October 17, 2022
“a lot of pension funds had bought into funds” which pension funds; the workplace pension funds?
October 17, 2022
It sounds to me that the BoE is being governed for political rather than financial reasons. Spook the markets then blame it on the mini-budget. You also have Biden interfering telling us to reverse the tax cuts when the USA has much lower tax rates than the UK. I wasnāt in favour of much of the mini-budget but Trussās weakness in sacking the chancellor and putting in the globalist puppet Hunt has signed the end for her short stint as PM. The Conservative party has inflicted so much damage on itself that I doubt it can recover in my lifetime. To be so foolhardy can only have been designed by the Globalists. They want to take away the democratic voting rights of their members, what next, will they conflate another crisis to take away the voting rights of the public? Are we to be governed by a dictatorship like China? We already know Hunt’s view on lockdowns and mandatory jabs.
October 18, 2022
I think it is true that the Bank of England is being used for political purposes. What I find hard to understand is why people think it wouldn’t be!
October 17, 2022
Spot on as usual. Wow – MPs did not know how the Bond Market works! I wonder if the BOE knows how it works?
October 17, 2022
But why was the Bank worried about pension funds since, as Frances Coppola points out, it “doesn’t have any mandate to prevent pension funds going bust”?
Her surmise is that the pension funds were long of interest rate swaps, were seeing margin calls as rates rose that they attempted to fund by selling gilts in an increasingly difficult market, and default by them on swap contracts would have materially harmed the bank counterparties, not least as many of the swaps are centrally cleared. Hence the Bank acted to forestall disorderly markets, greatly worried about systemic meltdown, but not to rescue pension funds (restoring liquidity to the gilt market was incidentally helpful to them) but to rescue banks.
All that surely could and likely would have happened even without Kwarteng’s maladroit special fiscal operation since the trigger was the Bank wishing to drive up longer dated interest rates that it failed to do with a light enough touch. Shameful.
October 18, 2022
As I think has been pointed out on here, the Bank has an obligation to manage inflation. Something it has failed miserably at. Some think the Gordon Brown magic trick of Bank independence was a clever wheeze. Some would be wrong!
October 17, 2022
MP’s need lessons in how the markets work? Why are they MP’s? Total amateur stuff as we suspect. What next, doctors asking how to diagnose illness.? My goodness we are worse off than I thought with ignoramuses in the House daring to vote on complex issues affecting people’s lives. The fact that they have been in office and never bothered to find out shows the quality we have in the House. What a shower!
October 17, 2022
“The ECB is not threatening to sell some of its huge holdings of bonds as it is worried what that might do to their bond markets” – and the very existence of the Evil Empire! There have of course been no bids in quantity for Italian government debt for a long while except from the ECB. The idea of it becoming a seller would be devastating.
October 17, 2022
So if HMG had done nothing , are you saying no bond volatility would have happened?
How is the BOE supposed to manage the inflation target? Is this not “over spending & waste” or political fiscal dominance in action? Is the BOE going to let inflation rip maybe to 20%-25% pa?
So lets see what happens when the Fed goes another 75-100 bps , with words like expect more.
The problem is the creation of funny money created out of thin air dispensed by 5th column bureaucrats with no democratic accountability or constitutional accountability. IMHO we are not a democracy.
October 18, 2022
It seems fairly obvious that the Bank has been wedded to low interest rates and manipulating the money supply for far too long. Perhaps encouraged by a government that is far to fixated on “maxing out the credit card”. I don’t think this is something that anyone can lay at Liz Truss’s door. And in fact the modest tax changes that were announced were finally an acknowledgement that sometimes governments should grapple with economics. We can only wonder at the mindset of those seeking to attack her over this.
October 17, 2022
Could you explain how brexit is supposed to work?
Thanks.
October 17, 2022
I believe it involves the EU caving in to our demands, because they need us more than we need them, and we hold all the cards. I expect the German carmakers will be along to take our side any day soon
October 18, 2022
The German car makers will be shutting their factories and selling up to China thanks to bad energy policy. The BMW relocation of EV manufacture from Oxford is just the tip of the iceberg.
October 17, 2022
We in the UK make our own decisions independently without the EU interfering.
October 17, 2022
We sit here laughing, crying, bemused, furious, agitated, bewildered and finally numb that our Establishment appears to endorse such an idiotic f**k- up!
October 17, 2022
Well NHL..we revert to being an independent nation just like the other 150+ nations who decide on their own futures.
October 18, 2022
In what sense work? I guess you understand the idea that leaving means we are no longer obliged to follow the EU orthodoxy? But instead are free to make our own decisions in our own interests. It would be quite nice if someone pointed this out to the mandarins!
October 17, 2022
Am I right in thinking that UK pension funds have to hold a certain amount of gilts in their portfolios? If that’s the case then the requirement should be removed. I count myself as a sophisticated ivestor and wouldn’t touch gilts with a barge-pole. And I’m not too fond of commercial paper either.
October 17, 2022
it is interesting how many people commenting on the various current events have little to no idea what they are talking about. Strangely given the quality of current output that would have to extend to what we politely refer to as the quality news outlets. Which is why it is good to see your article here. The other area of current misinformation seems to be around the constitutional arragements regarding Prime Ministers and the Cabinet. We seem to live in a time when many really don’t seem to care to understand the rules by which we organise our country and our government! Most strange!
October 17, 2022
I’m so sorry for Liz Truss, and Kwasi Kwarteng. The savagery they’ve had to face is appalling. This is a very sad and ominous time for our country.
October 17, 2022
Thanks Sir John for providing a āBonds for Dummiesā today. I guess It will be useful to a number of regular contributors to this blog.
As a father of three children all with mortgages and as a pensioner it has also been comforting to learn that the āgyrationsā in the market are essentially linked to the behaviour of the BoE.
And obviously all the little things that happened today to the exchange rate and the stock market must have come from some flapping of butterfly wings in some distant country.
October 18, 2022
It is interesting to speculate on whom was responsible for making those butterfly wings flap!