The potential bond crisis most people have never heard of
While 007 goes from strength to strength, his financial namesake may be heading for a fall
"The name's Bond," goes the famous line. But in this case, it's not James Bond. While nearly everyone knows every detail about the 007 super spy, his lesser-known financial namesake is many times more important.
The James Bond franchise is expected to continue strongly with the autumn arrival of Daniel Craig speeding through the streets of Rome in SPECTRE, but those in the financial know worry about the spectre of the other kind of bond heading for a crash.
Four out of five bond traders worry the market could collapse in a disorderly sell-off.
- Bank of America forecasts another rate cut for Canada
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And while Bond villains jump right out at you, bond villains are hard to finger.
At their most basic level, bonds are anything but complicated. They are simply a legal arrangement where one person agrees to lend money to someone else for a fixed length of time at a fixed rate of interest.
Popping the bond bubble
In the public imagination, if we think of them at all, bonds are the epitome of safety. Which is why it is strange to read in one of the world's most reliable business publications, the London Financial Times, that experts are terrified of an imminent crash in bonds that could destabilize the global economy.
In the financial world, bonds are called "fixed income" investments. That's different from stocks. When companies need money, sometimes they sell pieces (or shares) of themselves that go up and down with the perceived value of the company. Those are stocks.
Unlike stocks, bonds represent a long-term loan to the company's shareholders. Bondholders don't earn any more when a company does well. But if the company gets into trouble, bondholders get their money back before shareholders get a penny. Thus their reputation for safety.
But of course there is no investment so safe that financial markets can't bring out the risk.
Volatile and very big
There are several reasons why bond markets are frightening. One is their size. The Bank for International Settlements has pegged global outstanding debt in bonds in the range of one hundred trillion dollars, one of those numbers so huge it is almost meaningless to our daily lives.
The other is that for all their safety and stability, the market where people trade bonds has become hugely volatile, something that needs a little explanation to someone not familiar with that market.
A single fact makes bond trading confusing: the value of bonds moves in the opposite direction to interest rates.
But even that is simple once you get your head around it.
Let's say a few years ago you offered to lend a company (or the Canadian government) $1,000 in the form of a 30-year bond at, say, seven per cent interest. You don't have to keep if for 30 years.
If you sold it on the bond market this spring when interest rates were only two per cent, the earnings on your seven per cent bond are more than three times what bonds are earning now, so your bond would sell for much more than the $1,000 you paid for it.
On the other hand, if you bought a bond this spring when rates were two per cent and then sell it in a few years when interest rates are four per cent, your $1,000 bond would only be worth about $500.
The detail is more complex of course. But the principle is plain. Falling interest rates make existing bonds worth more. Rising rates make existing bonds worth less.
Not so safe
Over the last several decades, steadily declining interest rates have made buying bonds very lucrative and very safe. But when interest rates switch direction and begin to climb once again, bonds purchased as a safe haven no longer seem so secure.
Throwing an extra screw in the works these days is the fact that the biggest buyers of government bonds have been governments themselves, and as they stop there may be more bonds than buyers. Fears of the domino effect of a Greek default have only added to the latest concerns.
To some traders, an unnecessary rise in interest rates is the villain of the piece. To others, the fault lies with derivative traders hoping to make short-term gains on what should be a long-term investment. If the bubble argument is right, it is just a matter of buyers getting greedy and irrationally exuberant, forgetting that rates can rise as well as fall.
When he announces the Canadian key lending rate this week, Bank of Canada governor Stephen Poloz may be worried about the impact of higher rates on the housing market and record consumer debt. Other central bankers including the U.S. Federal Reserve's Janet Yellen must also take the global bond market into their calculations.
Because when it comes to pension funds and other large investments, the bond market may have a licence to kill the full value investors have been expecting.
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