Why bond price matters - Apocalyptic cuts package fails to get State borrowing off life support


The markets have spoken and the verdict is that Brian Lenihan's 6 billion euro package of public sector cuts and extra taxation on ordinary workers is not going to work. The confidence in Ireland's future in the international money markets is reflected in the yields in Irish sovereign bonds. These bonds are the IOUs the government issues to borrow the money to plug the shortfall from income to spending. They vary from 2 to 14 years in duration before the money borrowed has to be repaid, the 10 year being the one most closely followed by market watchers. The yield on a bond is the interest rate the state has to pay the lenders. In these last few days increasingly urgent stories in the business pages of the papers have been warning about the dangers of increasing bond yield spreads.

A spread is the difference between two rates of return expressed as percentages. So today the German 10 year bond has a yield of 2.25 % and the Irish 10 year has edged down fractionally to 7.61 % so the spread between the two is 761 - 250 = 511 basis points (1 basis point - 1/100th of a percentage point). What this means is that the Irish State is having to pay more than three times as much to borrow money to plug the deficit gap as Germany or the larger Eurozone countries. It also means that Irish banks can borrow money from the ECB at 2.25% to buy Irish bonds at 7.61 % and pocket the difference, which is effectively coming out of the pockets of Irish taxpayers.

So what do these high rates mean and why are they a threat? First of all they mean that more of the Government's income is going to have to be spent on interest for borrowing money, which means less for services for us. But the larger threat is that we are now above the levels of interest that Greece was faced with when it went bust in May this year. The larger threat is that if these rates stay high, Ireland will soon follow Greece into the clutches of the IMF and its dreaded "Structural Adjustment Programmes".

Bonds are first sold when they are issued by the National Treasury Management Agency. But, once issued in that first, "primary" sale, there is also an ongoing secondary market that trades bonds every financial trading day. Currently traders are saying that the only body still buying Irish sovereign bonds is the ECB. In other words, even the last days bond yields, the highest ever, are being kept artificially low by ECB intervention.

Hence yesterday's big fanfare by Brian Lenihan around his 6 billion package. Yet today, the yields have hardly budged from Thursday's historic high. The fact is that the budget deficit has been caused by the recession. People losing their jobs means a loss of income to the state and an extra outgoing for unemployment benefit. A simple equation which means that the deficit isn't going to start reducing significantly until unemployed people start getting work again. Today the capital markets have judged Lenihan's plan and decided that it is most likely going to result in more recession, more unemployment, worsening debt and increasing certainty that the State, sooner or later, will have to default on its debt.

WORDS: Paul Bowman