After a month of being exciting for all the wrong reasons, Britain’s bond market is at last settling down. All it took was an emergency bond-buying programme from the central bank, the defenestration of a chancellor, the installation of a sensible successor, the humiliation of a prime minister and the shredding of a vast unfunded tax-cutting package that set the fiasco in motion.
At the height of the chaos, Britain’s five-year borrowing costs were higher than those of Italy and Greece, two countries that have difficult relationships with their lenders. Although the markets are now calmer, the country’s sovereign bonds, or “gilts”, still trade at much higher yields than they did before the self-inflicted blow. Dario Perkins of ts Lombard, an investment-research firm, has dubbed this a “moron risk premium”. What does the premium mean for Jeremy Hunt, the new chancellor, as he seeks to restore order to the country’s finances?
It is important to remember that countries are not companies. Familiar measures from the corporate-bond market do not mean the same thing when applied to sovereign debt. If two American firms borrow in dollars at different rates, the implication is that the one with the lower rate is the more creditworthy. In some cases, this works for government debt, too, such as for countries like Argentina and Colombia that borrow a lot in another country’s currency (the American dollar), or for those like Germany and Italy that share a currency and a central bank. But for the most part it does not. America’s ten-year yield is higher than Slovakia’s. That does not mean America’s government is the riskier prospect. Similarly, Britain has not suddenly morphed into one of the euro zone’s more troubled members.
Instead, government-bond yields reflect a wealth of interlinked factors. Chief among these is the expected future path for the interest rate set by the central bank whose currency is being borrowed. There is information about inflation (which may force the bank to raise rates), gdp growth (which may make it more sanguine about doing so) and unemployment (which may make it more reluctant). There is a judgment about the central bank’s own hawkishness or dovishness.
Then there are the other risks. If the currency is likely to weaken, foreign investors should demand a higher yield to compensate. If inflation remains untamed, the value of both interest payments and principal will be eroded, also requiring a higher yield. There is little doubt the actions of Britain’s government have pumped up gilt yields. But these yields say as much about the country’s economic trajectory as they do about its government’s credibility with investors.
One way to sharpen the picture is to take the government-bond yield for a given maturity and subtract the average interest rate the market expects from the central bank over that period. Known as the “asset-swap spread”, this is analogous to the credit spread for a corporate borrower. For the long-dated gilts that sparked Britain’s near-meltdown, the measure did indeed balloon in the last week of September, before falling back to lesser levels once the Bank of England intervened. Yet asset-swap spreads are also contaminated by other factors, like demand for government debt for use as collateral or liability matching.
A better option is to look at the cost to insure a government’s debt. Credit-default swaps are bilateral contracts where one counterparty agrees to insure the other against the loss due to default on a specified bond, in exchange for a fixed stream of payments. The fixed stream is quoted as a percentage of the amount insured, or “spread”, and implies a probability of default for the issuer of the underlying bond. Britain’s credit-default swaps trade at far lower spreads than those of Italy, which means the market perceives Britain’s risk of default to be much lower.
If yields are a bad guide to risk, their volatility is a better one. Daily movements are measured in “basis points”, or hundredths of a percentage point. It tells you something that the intraday range for British 30-year gilts on September 28th spanned 127 of them, more than the annual range in all but four of the last 27 years. Before the blow-up, the largest daily increase had been a mere 29 basis points. Since then, similar-sized moves have become routine. Britain’s sovereign debt is not flashing red with bankruptcy risk. But its chancellor, and his successors, face a long and grinding slog to convince investors that gilts are once again a safe bet.■
Read more from Buttonwood, our columnist on financial markets:
Credit-default swaps are an unfairly maligned derivative (Oct 13th)
The world’s most important financial market is not fit for purpose (Oct 6th)
Investment banks are sharpening the axe (Sep 29th)
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