Bond Markets Will Rule

 Thanks to Buck Klemkosky for being our guest blogger this week. Buck has been the dean of the SKK Graduate School of Business at Sungkyunkwan University, Seoul, since 2004. SKK GSB is the top MBA program in Korea and one of the top programs in Asia. Previously he was a finance professor and served as associate dean and chair of the finance department at the Indiana University Kelley School of Business. He follows the markets closely as a money manager as well. A version of this article in the Korea Times appeared on Dec. 11, 2011.

Recent elections in Europe show popular support for anti-austerity fiscal programs. But the results of elections may not be the final arbitrator of fiscal policies, especially in Europe. As contagion spreads from country to country, it appears as if the bond markets will be the primary force imposing discipline on European governments, central banks and commercial banks.

Two of the primary signals for sovereign debt problems are credit spreads and credit insurance. Investors compare sovereign bond yields to those of Germany or the U.S. to assess the probability of sovereign debt default or some sort of restructuring. As credit default spreads widen, the market places a higher probability on potential default. Investors also pay attention to how much it costs to insure against sovereign debt default in the credit default swap market.

Of course, politicians don’t like discipline, especially market-imposed discipline. Their first reaction is to blame higher bond yields on evil speculators. But politicians lose sight of what markets do. One of their primary functions is to process information and set prices for financial assets. For bonds with fixed coupon rates, the bond price determines the yield to maturity, if investors buy today and hold the bond to maturity. Once the coupon rate is set, if investors want a higher yield because of higher default risk, they can get it only by buying the bond at a discounted price. So there is an inverse relationship between bond yield and bond price. Bond investors also do not have to buy the bond and hold to maturity. They can anticipate or speculate on changed in yield and hold for time period less than maturity.

Burt the basic question is: Should you trust the markets? If you believe that the bond market for sovereign debt efficiently processes information, then bond prices do reflect public and private information. This is referred to as the Efficient Market Hypothesis in finance. Informational efficiency is a matter of degree, but research shows that bond markets are fairly efficient at processing information and setting prices and yields.

What does it take to have an efficient bond market, even with speculators? Foremost, you need a large number, not all, of investors who are rational and compete for information to value bonds. The incentive to search for and analyze information comes from trying to maximize returns for a given level of risk. Markets can also be efficient even with speculators present as long as they have diversity of opinion, independence of thought and use multiple sources of information. Speculators invest their own capital and assume risk, so they have a big incentive to get it right. So speculators do not necessarily separate the financial markets from the real economy or make prices more volatile than economic fundamentals warrant. Speculation also does not necessarily cause asset bubbles (irrational markets). So the collective wisdom of markets and the self-interests of investors can provide the most efficient prices.

Of course, hindsight shows that asset bubbles do occur:  technology stocks (1996-2000), housing in many parts of the world (1996-2006) and various commodities. But the bond markets have not been as subject to irrational exuberance and collective investor euphoria as other asset classes. If bond yields don’t reflect economic fundamentals in many countries today, it is because central banks have kept interest rates abnormally low as a monetary tool to help slow-growth economics.

Governments have proposed or imposed various rules and regulations to curb perceived speculation: place a tax on financial transactions, ban short selling, put position limits on derivatives contracts and eliminate or curtail the use of some products such as credit default swaps. Most of these are imposed with little empirical evidence as it is easier to blame speculators than to address real economic problems such as deficits, promises that can’t be met and sovereign debt.

What the bond markets are telling us is that the euro zone has massive problems that probably can’t be fixed in the short term. The PIGS (Portugal, Ireland, Greece and Spain) have been replaced by the PIIGS (add Italy). The source of the financial contagion has been the European Central Bank and the politicians doing too little too late.  While politicians in some countries worry about moral hazard by reducing incentives to reduce deficits and restructure economies, others believe that austerity programs will cause recessions and widen deficits and increase the sovereign debt problem.

The interconnectedness of European banks and sovereign debt has created a perfect storm in which investors are losing confidence in some euro zone countries and banks.  Investors realize that some of the countries are too big to fail, but also perhaps too big to save, given what has been proposed thus far. The probabilities of the collapse of the single euro zone currency have increased and will continue until bold actions are taken to stop the contagion. Confidence has to be restored decisively.

So European politicians and bankers have not liked what has been happening in the bond markets. More than one has denounced the markets and stated the need to establish or re-establish the primacy of government policy over the markets. But the bond vigilantes are a tough group. If they could speak with one voice, it would be: “The markets aren’t the problem. It’s the banks and the politicians who caused the mess. If you don’t like what we, the markets, do, don’t borrow money in the bond markets.”

As James Carville, advisor to President Clinton, famously stated, “He wanted to be reincarnated as the bond market so he could intimidate everyone.” Market discipline will work when everything else fails, especially politicians and government.