Why is the bond market so important?

Three decades ago, the political analyst and adviser to President Clinton, James Carville, made a memorable statement. Paraphrasing, Carville said that if he were to come back to a second life, he originally would choose to be the Pope, the President, or a major league baseball player with a 400 bating average.  But he then said he now changed his mind.  He would come back as the bond market, because the bond market can intimidate anyone.

Obviously, Carville was engaging in some humor, but there was a reality behind his joke.  The Clinton Administration began in 1993.  There had been a recession from 1990 to 1992, and inflation had also been an issue.  So, the new Administration knew households and businesses were still aware of these two economic challenges.  But so too was the Federal Reserve.  To address the inflation concern, in 1994 he Federal Reserve decided to raise its key interest rate, with other rates in the economy also rising.  The bond market crashed, and Carville made his famous statement.

A crashing bond market is not only a thing of the past.  In August this year we had another bond crash.  So, what exactly are bonds, and what is a bond market crash? Further, using the words of James Carville, why can the bond market intimate anyone?

A bond is simply a mechanism for borrowing.  Bonds have been used for centuries, with the first bond issued in 13^thcentury Italy.  Today, bonds are mainly used for borrowing by businesses and governments for large, long term investments. 

For example, suppose a company wants to build a new factory, which will cost billions, but will last for many years.  The company doesn’t have the cash to build the factory, so it will issue bonds to raise the money.  The bond will have a fixed interest rate associated with it, which determines how much interest will be paid regularly to the borrower each time period, usually a year or month.  The bond will also have a term, which is the number of years the before bond’s original value is paid back to the lender.  In short, the lender buys the bond today, receives on interest payment each time period, and then after a specified time period the lender receives back the original amount of money that was loaned.

Governments, including local, state and federal, are also big users of bonds.  Local and state governments use bonds to raise money for expensive public projects, with infrastructure like roads, bridges, and public buildings being common examples. A benefit of using bonds to finance these big projects is that they spread the large cost of the project over many  years and over several generations of citizens.

The biggest user of bonds is the federal government, where bonds are used to finance the national debt.  Ironic to some, these federal bonds are considered one of the saftest of investments, mainly due to the fact the federal government has never missed an interest payment or final pay-off of their bonds.

Bonds do not have to be kept by the investor for their full term.  That is, a bond can be sold and bought in an open market.  While this gives bond owners options, it can also lead to bond surges as well as bond crashes.  The reason is bond buyers are always comparing the fixed interest rate paid on existing bonds to the interest rate paid on new bonds.  If the interest rate on new bonds is lower than the interest rate on existing bonds, existing bonds  become more valuable and their sales value rises above their initial value.  But if the interest rate on new bonds is higher than the fixed interest rate on existing bonds, then the value of existing bonds falls.  This latter situation is called a “bond crash.”

 Why is a bond crash so feared? Won’t the negative effects of the crash be confined to bond holders who see the value of their bonds drop?  Actually, the impact goes beyond the bond market. This is because when bond interest rates rise, most other interest rates, such as those on mortgages and personal loans, also rise.  Higher interest rates tend to slow the growth rate of the economy, which can lead to a recession or worst.

The recent bond crash was sparked by several factors, including continuing worries over inflation, the rising federal budget which generates more borrowing that pushes up interest rates, and news that the Federal Reserve is considering raising their interest rate.

In summary, a bond market crash is a sign of major worries about the economy by both businesses and investors.  It gets our attention and causes worries about where the economy is headed. 

Hence, virtually everyone who has a stake in the economy worries about a bond market crash.  So, was James Carville right that the bond market can intimate anyone?  You decide.

Walden is a William Neal Reynolds Distinguished Professor Emeritus at North Carolina State University.  His new book, “North Carolina in the Anxious Age” will be published by The UNC Press in October.