Debt markets are in trouble
The first sovereign bond was issued by the Bank of England to fund a war with France and has turned into the $128tn market that it is today. (ICMA, 2020) While it may be far less exciting to most than its older brother the stock market, the bond market is the foundation of all markets. As legendary investor Ray Dalio says, “The bond market is the most important market in the world”, and right now that market is in a dire state with huge financial implications.
What is the bond market?
Bonds are debt or a way for nations and corporations to borrow money. Instead of going to the bank to borrow money in one go, they can split the money into chunks and borrow from groups of people. This allows borrowers to borrow lots of money and lenders to reduce their risk. For instance, if Amazon needed to borrow $1bn to build data centers they wouldn’t be able to walk into a bank and ask for it all, but they could issue one hundred bonds for $10m and raise money that way. Since its exception, the bond market has allowed nations to borrow huge amounts of money to grow whether that be in building new bridges for cities or investing in a new warehouse. Historically, however, bond markets were reserved for only the most trustworthy borrowers such as governments and excellent companies, but that all changed in the 1970s when Michael Milken expanded the “junk bond” market. Allowing smaller companies with lower credit ratings to start borrowing money through the bond market, while they had to offer lenders a much higher rate to borrow money, the inception of the junk market opened up the beauty of credit lending to thousands of new companies. The bond market has also turned into a lucrative market for investors looking to park their money. Instead of risking their money a stock improving lenders, endowments, and investors can lend money to get an almost guaranteed return. Typically, most large institutional investors allocate around 40% of their money in the market market hoping for steady guaranteed returns (WSFS). Now large asset managers bundle together hundreds of bonds at one financial product, so investors can buy one security and get the return on hundreds of different bonds combined and those hundreds of different bonds can fund the financing needs of hundreds of different companies. Safer and more risk-averse investors like endowments or people getting close to retirement end up placing most of their money in fixed-income securities made up of bonds. As bonds are debt they are the foundation of all borrowing and banking costs. Banks set their lending interest rates to the rates of foreign bonds, so whenever the US 30-year bond moves, the rate that lenders charge also moves. In recent years alternative asset manager have turned to private credit or the bond markets to invest their clients’ money in a new form of lending known as “shadow banking”. Instead of going to banks to loan money companies are going straight to “shadow banks” to borrow huge amounts of money in the form of bonds. Since 2010, the total assets in the shadow banking industry have passed that of the traditional banks.
Overall, the credit or bond market plays a huge role in the borrowing and investing side of the global economy. With companies requiring it as a source of capital to function and grow, investors placing their money in bundles of bonds hoping they’ll increase in value, and banks and other lenders basing their rates on foreign bond rates just about everyone in the financial market is dependent on bonds in one crucial way or another.
The current state of the bond market
In the last five years, a number of things have happened that have altered the state of the bond market, causing bond yields (the cost of borrowing the money) to surge and bond values (the value of the assets investors hold) to drop. Major global economies like the US, UK, and Italy are all experiencing soaring interest rates making it more expensive for the government to borrow money which further exacerbates the budget deficit issues.
A multitude of different things have affected the yield markets including Covid, the Federal Reserve raising the federal funds rate, and global uncertainty.
How this affects our economy
Surging bonds could be devastating for our economy. The US deficit has already reached $33tn and increasing borrowing costs will just put further pressure on this growing difference requiring more and more government budget to pay off debt. Now the government might not be able to take on new projects just as investing in infrastructure or healthcare because it won’t be able to move the money at a good enough rate. A similar problem will happen with companies trying to invest in their future. The crisis in the bond market will mean that fewer investors will be willing to lend money by buying bonds making ti harder for companies to raise money and those that do will have to pay a large premium making many projects too expensive to take on. And finally, how will this affect everyday Americans? People hoping to buy houses or cars won’t be able to afford the high-interest rates that lenders are charging. Since all banks base their rates on global bond rates, if the bond rates are increasing the rate they’ll charge consumers will also be very high. Every American who dreams of buying a car or first home simply won’t be able to. Also, Americans coming close to retirement could have their fortunes wiped out in the bond market. Since, most Americans allow around 50% of their retirement savings into fixed income, if fixed income or debt assets decrease in value due to high yields, many Americans will have their savings wiped out and left unable to retire.
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