Top alert for 2014: MYGN (50%), LIVE (45%), CTIC (115%), KOOL (88%), PZG (32%), GOLD (6%), IOC (6%), RSOL(18%), PLUG (70%), IMMU (26%)

Thursday, June 28, 2012

What is Euro Bond and Why does it matter ?

The idea of eurozone economies clubbing together to issue bonds representing all 17 member nations has been gathering momentum. And it has some pretty influential backers, including new French President Francois Hollande, Italian Prime Minister Mario Monti, and the President of the European Commission, Jose Manuel Barroso. But those that really matter are less keen. The German government has said eurobonds "don't make sense" right now, given that individual member states conduct their own economic policies. It is also concerned the introduction of such bonds could reduce the resolve of highly-indebted governments to balance their budgets.
There does, however, appear to be a compromise in the works. The Germans seem open to the idea of "project bonds" that can be used to finance infrastructure investment across Europe.
But what are eurobonds and project bonds (neither of which actually exists yet), and what are the government bonds on which they are based?

What is a government bond?
Governments borrow money by selling bonds to investors. A bond is an IOU. In return for the investor's cash, the government promises to pay a fixed rate of interest over a specific period - say 4% every year for 10 years. At the end of the period, the investor is repaid the cash they originally paid, cancelling that particular bit of government debt.
Government bonds have traditionally been seen as ultra-safe long-term investments and are held by pension funds, insurance companies and banks, as well as private investors. They are a vital way for countries to raise funds.

What is a bond market?
Once a bond has been issued - and the government has the cash - the investor can hold the bond and collect the interest every year until it is repaid. But investors can also buy and sell bonds that have already been issued on the financial markets - just like buying and selling shares on the stock market.

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 Spanish bond prices.

What is a bond yield?
The bond yield tells the investor what the return on their investment is, and can be calculated based on the current price of the bond in the market. If a 100-euro bond is paying 4% fixed interest - in other words, 4 euros per year - and the bond can be bought for 100 euros, then the yield is 4%. If the bond price falls to 90 euros, then the yield will rise. That's because the investor is still getting paid 4 euros every year, and 100 euros at maturity, which is a much bigger return compared with the 90 euros they must put down to buy the bond.

Why do bond markets matter?
Because they determine what it costs a government to borrow. When a government wants to raise new money, it issues new bonds, and has to pay an interest rate on those bonds that is acceptable to the market. The yield at which the market is buying and selling a government's existing bonds gives a good indication of how much interest the government would have to pay if it wanted to issue new bonds. So, for example, Spanish 10-year bond yields have risen above 6% in recent years. That means that if the Spanish government wants to borrow new money from the bond market for 10 years, it would have to pay an interest rate on the new bond of more than 6%.

So what is a eurobond?
A eurobond would operate in exactly the same way as a government bond, except that all 17 member states of the eurozone would collectively guarantee the debt rather than a single government.
There are, however, many important questions about how a eurobond might work that remain to be answered. For example, if one government could not pay its share of the bond payments, would the other 16 governments step in and make the payments on its behalf? Would the government that got into trouble be required to prioritise its eurobond payments over its other debts? Would government bonds of the individual member governments continue to exist alongside the eurobonds? Who would decide how to spend the money raised via eurobonds? If individual governments could spend the money, then how much would each government be allowed to borrow using eurobonds and under what conditions?

How might a eurobond solve the crisis?
During the financial crisis, investors have been much less willing to buy the bonds of troubled southern European countries, and much more willing to buy the bonds of Germany and some other financially stronger countries. That has made it much cheaper for Germany to borrow, and prohibitively expensive for Greece, the Irish Republic and Portugal to borrow. The worry is that Spain and Italy may also find it too expensive to borrow. Introducing eurobonds would level the playing field - all governments would be able to borrow at the same interest rate.

Why does Germany object to eurobonds?
Germany has three basic objections. First of all, the Germans do not see why they should be on the hook for all of the debts racked up by their southern neighbours, which is what a eurobond would entail. Secondly, it may make it more expensive for Germany to borrow, because markets may consider the eurozone as a whole to be a more risky borrower than the financial strong Germans on their own. Thirdly, and most importantly, the German government is afraid that if they guarantee the debts of their eurozone neighbours, that will simply encourage the southern Europeans to borrow and spend more freely, making their debts even bigger and more unsustainable.

What about these "project bonds"?
The details are unclear, but it seems these would be issued by the European Commission. The borrowed money would be spent by the Commission on infrastructure and other growth-enhancing investments, and would ultimately be responsible for repaying the project bonds.
They would be similar to eurobonds to the extent that the EU governments are collectively bound to support the Commission and make sure that it can repay the debts. However, the amount of money involved in the project bonds would be far smaller than what is envisioned by the advocates of eurobonds. The Commission's entire budget is equivalent to about 1% of the EU's GDP, whereas most EU government budgets are equivalent to about 50% of their respective GDPs. Nor would project bonds do anything to reduce the borrowing cost of the southern European governments, although it might help indirectly if markets think that the infrastructure spending by the Commission will significantly help the southern European economies to grow.

No comments:

Post a Comment