Mike Walden
Three decades ago, James Carville, the political analyst and adviser to President Bill Clinton, 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 batting average. But he then said he changed his mind. He would come back as the bond market because it can intimidate anyone.
Obviously, Carville was engaging in some humor, but there was some 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 inflation concerns in 1994, the 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, though, is not just a thing of the past. In August of this year we had another bond crash. So, what exactly are bonds, and what is a bond market crash? And, 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 13th century 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 bondholder each payment period, usually monthly or annually. The bond will also have a term, which is the number of years before the bond’s original value is paid back to the lender. In short, the lender buys the bond today, receives a regular interest payment 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 several generations of citizens.
The biggest user of bonds is the federal government, which uses bonds to finance the national debt. Ironically, to some, these federal bonds are considered one of the safest of investments, mainly due to the fact the federal government has never missed an interest payment or final pay-off of its 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 that 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 bondholders who see the value of their bonds drop? Actually, the impact goes beyond the bond market. That’s 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 worse.
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 was considering raising its 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 raises concern 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 intimidate anyone? You decide.
Mike 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 and is now available for pre-order.