America s Bond Market Blues

There would be worries that adding cocos to sovereign bonds might raise governments borrowing costs.

The US bond market agrees with me.

Adding cocos to government bonds will require solving a host of technical problems.

How Scary Is the Bond Market?

It is no secret that sovereign bonds carry significantly higher borrowing costs than concessional debt does.

The bond market and share prices have responded to all of this bad news in a predictable fashion.

Indeed, the bond market channel is unlikely to boost growth.

Hence, the Fed s intervention in the housing market is really an intervention in the government bond market the purported switch from buying mortgages to buying government bonds is of little significance.

The healing process is also evident in Europe, though, unfortunately, it is effectively limited only to sovereign bond markets.

Sovereign cocos have the advantage that their activation would not constitute a credit event triggering the credit default swaps written on the bonds. The existence of large quantities of CDS, together with uncertainty about who has written them, has fed the reluctance to proceed with restructuring.

The first relies on intervention by the central bank in the event of a threat to the sovereign debt market.

Until there is a market for such bonds, we cannot know what the price will be.

Medium term fiscal reform, for its part, will be pushed by bond market vigilantes.

Sovereign obligations, such as bonds, are commonplace in the capital markets, and demonstrate strong investor demand and confidence.

Indeed, the stock market is an important component of any modern economy.

The sub prime crisis has diverted attention from rising fears about Sovereign Wealth Funds (SWF s) as the new bogeyman of global finance.

Bond market vigilantes already have taken aim at Greece, Spain, Portugal, the United Kingdom, Ireland, and Iceland, pushing government bond yields higher.

The ECB s announcement of a new program to purchase sovereign bonds has lowered market interest rates.

In fact, the success of banks in issuing cocos suggests that investors do have the appetite for them.

So why are an increasing number of developing countries resorting to sovereign bond issues? And why have lenders suddenly found these countries desirable?

Encouraging participation by foreign investors is a quick way to jump start local bond market activity.

Surprisingly, the bond market still seems almost oblivious to this risk.

Noting the increasing voluntary use of collective action clauses in sovereign bond contracts by both developing and developed countries,

Countries contemplating joining the bandwagon of sovereign bond issuers would do well to learn the lessons of the all too frequent debt crises of the past three decades.

But the minute the sub prime crisis subsides, anxieties about SWF s will return.

Nor is there any pressure from bond markets to concentrate the minds of policymakers.

While Europe has succeeded in stabilizing its sovereign bond markets, financial intermediation for small and medium size enterprises remains highly disrupted.

To ensure that their sovereign bond issues do not turn into a financial disaster, these countries should put in place a sound, forward looking, and comprehensive debt management structure.

Investors subsequent efforts to price in the risk of a eurozone breakup not the volume of sovereign debt caused bond yields to spike.

Extending this idea to sovereign debt, government bond covenants could stipulate that if a sovereign s debt GDP ratio exceeds a specified threshold, principal and interest payments to bondholders would be automatically reduced.

It could do so by buying Italian and Spanish bonds in the secondary market with the pre announced intention of keeping their sovereign interest rates below a certain threshold for a certain time.

The solution suggested by the Governor was to borrow about 400 million on the bond market to offset the deficit.

A decent pan European economic recovery, and successful gradual fiscal consolidation, would allow the distressed sovereign bonds to rise in value over time. Until then, the jockeying will continue over who will bear the losses, when, and how.

To the extent that this new lending is based on Africa s strengthening economic fundamentals, the recent spate of sovereign bond issues is a welcome sign.

Objections to the idea start with the question of whether there would be adequate demand for these novel sovereign debt instruments. In fact, the success of banks in issuing cocos suggests that investors do have the appetite for them.

But the stock market does not guarantee returns it does not even guarantee that the stock values will keep up with inflation and there have been periods in which they have not.

The bonds can be sold to a worldwide market by insurance companies that incur major risks by writing policies.

The Asian bond market and Asian bonds are thus mechanisms for financing for development that also promote greater regional economic stability.

NAIROBI Until the global financial crisis erupted four years ago, sovereign bonds had traditionally been viewed as reliable, virtually risk free investments.

And, to the extent that there is even an informal price target associated with the ECB s commitment to purchase bonds, foreign outflows, at least from the sovereign bond market, are automatically replaced, in full, with ECB cash.

And the international bond market has expressed its approval by cutting interest rates on Italy s ten year bonds to 4.8 , and on Spain s to 5.5 .

In the eurozone, banks are vulnerable to sovereign debt crises because they hold a lot of government bonds frequently issued by their country of origin.

The semifinal between Italy and Germany presaged the apparent willingness of Chancellor Angela Merkel to give in to Italian demands for support of the government bond market.

That is the future that the bond market sees for America a slack and depressed economy, if not for the next generation, at least for most of it.