Spend Spend Spend

Today we will contemplate the impact of the bond market on government spending.

First we must define what a bond is:

A debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing. The Federal government, states, cities, corporations, and many other types of institutions sell bonds. Generally, a bond is a promise to repay the principal along with interest (coupons) on a specified date (maturity). Some bonds do not pay interest, but all bonds require a repayment of principal. When an investor buys a bond, he/she becomes a creditor of the issuer. However, the buyer does not gain any kind of ownership rights to the issuer, unlike in the case of equities. On the hand, a bond holder has a greater claim on an issuer's income than a shareholder in the case of financial distress (this is true for all creditors). Bonds are often divided into different categories based on tax status, credit quality, issuer type, maturity and secured/unsecured (and there are several other ways to classify bonds as well). U.S. Treasury bonds are generally considered the safest unsecured bonds, since the possibility of the Treasury defaulting on payments is almost zero. The yield from a bond is made up of three components: coupon interest, capital gains and interest on interest (if a bond pays no coupon interest, the only yield will be capital gains). A bond might be sold at above or below par (the amount paid out at maturity), but the market price will approach par value as the bond approaches maturity. A riskier bond has to provide a higher payout to compensate for that additional risk. Some bonds are tax-exempt, and these are typically issued by municipal, county or state governments, whose interest payments are not subject to federal income tax, and sometimes also state or local income tax.

Read more: http://www.investorwords.com/521/bond.html#ixzz18tGdIkYm

We should also clarify how bonds are bought and sold. Typically transactions occur on an exchange, which is a marketplace where securities like bonds, options, futures and commodities are traded. There is another type of bond is an OTC (over-the-counter) bond. These bonds are usually issued by private or public corporations. This type of bond is not listed on an exchange as it may not meet listing requirements, therefore it pays a higher yield to attract buyers to offset the additional risk.

To complete our understanding of the present circumstances of government finance we must emphasize that treasury bonds are essentially unsecured credit.  In a sense, the United States has a credit card with an enormous borrowing limit.  The interest rate the US pays on bonds (the credit card) depends on how well the bond market views the likelihood of full repayment. What is unknown, is the borrowing limit on the credit card. Rising long term bond yields should be a wake up call to Congress and the Federal Reserve as the chart below shows the US is now approaching that unknown borrowing limit:

What is more troubling than the steady increase in bond yields despite the attempt of QE 1 & 2 to suppress them, is the relentless increase in the gold to bond ratio shown below.

One interprets this chart that gold, the ultimate fear trade, is outperforming the long bond. A strong argument for this view is that central banks world wide, and in emerging markets in particular are increasing the size of their gold holdings as developed world central banks continue to increase the money supply.

My view is that as this ratio climbs, we are seeing stresses in the financial systems that we have not experienced before. A ratio above 10 is dangerous, and we have passed 11 and appear to be headed toward 12 quite soon.

I like to compare this to running an automobile engine at such high rpm that the red-line is exceeded. While it may be possible the bond market may tolerate this extreme level for a short time, I highly doubt it will last for more than a year or two. Something has to give.