Have had a few discussions with my classes about the bond market and how the issue of government bonds are so vital to fund their current spending. There is also an earlier post on Bonds – Bond Prices and Interest Rates
Bonds are essentially a form of debt. Companies and Governments sell bonds to raise money, promising to pay those who buy the bonds a return on their investment, which usually comes in the form of interest payments. The term, or duration, of a bond is important in understanding its risk. A ten-year government bond promises the buyer that it will return the original investment of the bond, plus pay a fixed interest rate, or coupon. So, say you wanted to buy a $1,000 in ten-year bonds (in the US $1,000 is the minimum purchase amount). You would expect to get an annual return which in recent years has been about 4 – 5%, plus the original $1,000 at the end of ten years. Since the interest rate is set for life investors are betting that the return they get is greater than inflation.
Once a bond has been issued they can be traded like any other security. The price of the bond will fluctuate as the outlook for interest rates changes. So, for example, if the markets think that interest rates are going to rise sharply, then the value of a bond paying a fixed rate of 4% for the next 10 years will fall. Bond prices will also fall if investors think that there is a risk of the government that issued the bond not being able to make the annual interest payment or repay it in full on maturity – and these are the fears which have been pushing down Irish bond prices.
European Countries and Bond Yields
Because of the poor financial condition that many Europen countries are in they have had to issue bonds in order to raise finance. However because of the risk associated with the loan they have had to offer much higher yields than is normally the case. Take for instance Greece and Ireland – they have had to offer returns of 11.8% and 9.1 respectively – see below.