- What drives bond prices?
- National debts and bond issuance
- A small club of nations
It’s August. There’s an unpopular president in the White House. Over the preceding three years, the U.S. government has heightened spending in an effort to stabilize a tumultuous economy. As the economy recovers, tensions increase between politicians who want to continue spending and politicians who advise restraint. Talks around increasing the debt ceiling become heated and extend to the 11th hour. A rating agency decides to strip U.S. national bonds of AAA status, and reduces the rating by one notch to AA high.
That was the story when S&P reduced its rating in 2011. It’s the same story in 2023 with Fitch reducing its rating.
What drives bond prices?
The value of any given bond is based on the timely and full payment of coupons and principal. The higher the rating of a bond, the more likely this payment is expected to happen. Typically, a bond downgrade reflects a decrease in confidence in that bond, with a resulting increase in the yield and decrease in price. Typically, when a bond is downgraded by one agency, it’s downgraded by other rating agencies in a relatively short time frame. When the U.S. was downgraded, there was no perceptible effect on its yield. Further, there was more than 10 years between downgrades by different agencies. What’s different in this scenario in 2023?
One interpretation is the debt level doesn’t matter, as espoused by proponents of Modern Monetary Theory (MMT). This theory argues that national governments can pay their debts through taxes or by simply printing new money, while assuming there’s endless demand for national debt. That is, if the debt is not absorbed by the market then it can be absorbed by a central bank. It also assumes there will be no consequences stemming from these dynamics.
Certainly, there are some smart proponents of MMT. But equally, there are some smart detractors. The main argument against can be made with an analogy. One might be able to drink two glasses of wine without any effect, but that doesn’t mean you can have ten glasses with a similar lack of effect.
We can go back a few years and attempt to test this theory. During COVID-19, national debt increased sharply with the respective central banks absorbing what wasn’t taken up by the market. But we saw how undoing this largesse resulted in significant bank rate rises. The situation was further confounded by the Ukraine-Russia war.
In other words, what may have been an economic inconvenience in normal times became an economic crisis in unusual times. Consider countries like Argentina, Venezuela or Zimbabwe where attempts to issue debt without end have ended badly.
National debts and bond issuance
Is there something special about national debt? There is when you consider the timelines involved.
We are human, so we largely think on a human scale. Early in our careers, we tend to be heavily indebted as we set up our household but by the time we retire, we usually carry a light debt load. We measure this debt lifetime in decades, but nations have a lifetime measured in centuries. And their debts are measured over the very long term, which tends to slow the debt issuance and repayment schedule. One could even argue that a nation is perpetual and doesn’t ever really need to fully repay its debt.
Further, is there something special about the U.S.?
Since at least the late 1800s there’s been a concept of American exceptionalism: individualism, equal opportunity, rule of law, democracy and laissez-faire economics all wrapped into something that’s uniquely – and exclusively – American. Today, I think it can be well argued that the U.S. is the dominant economy in the world. And this dominance does give additional latitude in debt issuance. The U.S. is able to run higher deficits, even proportional to GDP, than other countries. The “guarantee” of repayment offered by the U.S. is considered to be of better quality than the guarantees of many other countries.
Let me cherry-pick data to make a point. As seen in figure 1, the U.S. national debt-to-GDP ratio is comparable to that of Zambia or Mozambique.* But the U.S. is considered to be much safer, and that perception of safety really matters when it comes to the bond market. As an aside, Canada shows much better on national debt-to-GDP measure, but Canada has a larger portion of government debt at the sub-national level. Canada has improved its debt situation since its difficulty in the late 1990s, although overall levels in this country have once again started to creep upwards (see figures 2 and 3).
Figure 1: National Debt-to-GDP
Source: International Monetary Fund, 2021
*National debt refers to the total amount of money that a country owes creditors and represents the sum of past deficits. It’s made up of different types of debt, such as debt held by the public and federal government trust funds. This differs from government debt, which is the combined debt of different layers of government (e.g., national, municipal, and other levels).
Figure 2: National Debt to GDP
Figure 3: Government Debt to GDP
A small club of nations
Another advantage is the staggering size of the U.S. Treasury market. It’s more than twice the size of second-place Japan. Indeed, we need to add second through fifth place (i.e., Japan, China, France and Italy) to match the size of the U.S. national debt issuance. (If you wanted to avoid the uncertainty of China, you could substitute it with the combined debt of United Kingdom, Germany, India and Canada.) For safe, investible international debt securities, there really is no alternative to U.S. Treasuries. Canada does not enjoy this same prestige. Being 3% of global GDP, Canadian national bonds could easily be ignored by international investors.
On the flip side, the U.S. is in a very small club of nations that have absolute debt limits. Discussions on raising this limit present an opportunity for politicians to attempt to score points off each other. In the U.S., at least, the rating agencies’ comments on ability to pay may be affected less by the capacity of the U.S. economy and more by the machinations of political brinksmanship.
A bond downgrade is always a matter of concern. It must be noted that a downgrade of national debt – particularly U.S. national debt – involves very unique phenomena. Timelines for necessary action become substantially extended. As we saw with the IMF warning to Canada in 1990s, sometimes it requires an outsider’s comments to serve as the catalyst to corrective action by a national government.
A downgrade of U.S. national debt is a strong warning and is definitely something to watch, though it doesn’t require immediate action.
Source: International Monetary Fund
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