Remember Matteo Salvini? Salvini was the leader of the right-wing party Liga in Italy which managed, against all odds, to join forces with left-wing counterpart 5-Star Movement in 2018 to rule Italy for a brief period.
Salvini found himself catapulted from fringe politics to the position of Deputy Prime Minister of Italy for a brief sojourn, where he made clear his reservations against the European Union, Italy’s membership of the euro and his strong views on immigration and globalisation. His rhetoric played very well with large sections of Italians and he remains a popular figure in Italy.
But it wasn’t his strong words or his ability to ruffle feathers in Brussels and Berlin that ended Salvini’s period in power.
It was the Italian government bond market.
Government bonds are perhaps one of the most crucial financial instruments in the world. Certainly there is no other single instrument that is so closely tied with politics and policy. But to go further into what government bonds are, let us first talk about bonds.
Bonds are a type of debt that a company or a country can take on. I like to think of it as a loan broken into many pieces; pieces that can then be sold on and traded in a market, similar to stocks.
So for example: I can go to a bank and borrow a thousand pounds or I can sell a hundred bonds of 10 pounds each to a group of investors. It amounts to the same thing: I'm borrowing a thousand pounds. But instead of borrowing it from one bank I am borrowing it from many investors. It is a similar concept to crowdfunding, if that helps as a metaphor.
Why issue a bond rather than just take a loan? In the case of a country, the amount of money they need to borrow is in the billions of dollars or euros - and in some cases such as the U.S. and Italy – in the trillions. That isn't a sum of money that you can easily borrow from one bank or even a group of banks. Instead, what those countries do is they sell bonds to a huge group of investors – not just banks, but insurers, pension funds, hedge funds, asset managers like Fidelity and Blackrock and central banks like China and Singapore.
I won’t go more into detail about bonds here, but the key concepts to remember on bonds are coupon and yield – which are similar to the interest you pay on a loan – and price, which is the price at which the bond is trading. Price and yield are inversely proportional.
After the financial crisis of 2008 and the euro zone debt crisis of 2010-2012, many countries had to step up borrowing by huge amounts to stabilise the financial system. They then borrowed even more over the past two years to help combat the impact of COVID-19.
What this does is put a huge amount of power in the hands of bond investors. If a country steps out of line economically, bond investors will “vote with their feet” by selling the bonds of that country, which will increase the yield on those bonds (price goes down, yield goes up). That makes it more expensive for countries to borrow money, which is why British chancellor Rishi Sunak is worried. https://www.economist.com/britain/2021/06/03/rishi-sunak-is-worried-about-rising-interest-rates-he-should-relax
This is why bond investors are often described as “bond vigilantes” and Bill Clinton’s former adviser James Carville once said he would rather be reincarnated as the bond market than as any powerful human being. https://www.bloomberg.com/news/articles/2018-01-29/the-daily-prophet-carville-was-right-about-the-bond-market-jd0q9r1w
Government bonds are considered a safe investment and for good reason. When you buy German Bunds, for example, you are not just buying Germany’s debt – you are also buying into the strength of Germany’s institutions, its economic capacity and its ability to pay back debt. There’s a good reason why it has the highest rating possible from credit ratings agencies Moody’s, S&P and Fitch (more on this next time round).
So much so that German Bunds are actually negative yielding – i.e. you pay the German government for the privilege of lending to them! But more on that another day.
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