Bond Purchases as the Tool of Choice for Tackling the Debt Crisis?

The FT is reporting that the Christine Lagarde is the latest high-level official to offer tentative support for bond purchases by the EFSF as a central element in the reform of liquidity support measures.

Christine Lagarde, French finance minister, said France was ready to discuss allowing the eurozone’s €440bn ($588bn) bail-out fund to start buying bonds of struggling European economies amid signs of consensus that it would become the primary new tool for tackling Europe’s ongoing debt crisis.

How significant a development would this be? The first thing to note is that ECB bond purchases have failed to bring market yields to affordable levels. While probably helping to a degree, the ECBs secondary-market purchases have lacked commitment and provide no real certainty to investors on how high yields could rise.  Secondary market purchases by the EFSF are unlikely to be much more effective unless operated at a very different scale.

In principle, however, official primary-market bond purchases could provide guaranteed funding at some maximum interest rate. This maximum rate could be set high enough to create strong incentives to rely on market funding. I would presume that the total amount of funding would be capped and the programme would have a time limit. But because they involve purchases of ordinary bonds, concern about the seniority of official creditors should be lessened. Overall, the existence of such an official buyer of last resort should give market investors reasonable confidence that governments would be able to roll over their borrowing as bonds mature over a significant time period. The proposal has the potential to provide support to a country facing difficult market conditions without crowding out longer-term private investors from the market; such crowding out appears to be a major shortcoming of current support measures.

Of course, the devil is in the detail, and there is little concrete yet about how such bond purchases would actually operate. It is also unclear whether these new facilities would be available to countries already in support programmes. But it is an interesting development.

22 replies on “Bond Purchases as the Tool of Choice for Tackling the Debt Crisis?”

@ John

there’s also another element to consider on this.

At the moment, some bond funds (ie PIMCO) have been very proud and vocal about not having any exposure to peripheral bonds, assuring investors they have sold all their holdings etc, which right now, makes you look very smart and prudent. However, most active fixed income funds (as opposed to passive index managers) measure their returns against the benchmark indices, which still include the all the PIIGS except Greece (on account of last years junking).

As such, if we saw continued/increased PIIS buying like we saw this week, and further impressive movement in price and yields, you could actually end up with a situation where the benchmark index starts to significantly outperform anything thats possible from active management, who can only justify their management fee via outperformance vs benchmark. So, you will effectively end up forcing those either short or underweight PIIS bonds to buy back into market, even though they still somewhat do not want to. At that stage we could be looking at a very aggressive short cover, with very little inventory about other than at the central banks. This will be especially important and focused on Spanish and Italian government debt given their heavy weighting in the benchmark indices.

The Fed purchased over Euro1 billion of Portugal’s last bond. The ECB bought the bulk of the rest. There are no private bond purchasers to be crowded out. The ECB/Fed are desperate to hold the line against peripheral default. What does this tell us? It tells me anyway that we are in the end of days territory. All this BS from Trichet today about raising interest rates later this year! Half of one percent increase would put every one of the PIIGS into the toilet. If interest rates are raised it is the clearest signal that they intend splitting the Eurozone and hiving off the PIIGS from the Nordic Euro group.

Our best option is to go it alone. We could not be any worse off. Even if we stay shackled to the Euro we will need to completely re-define the function and operation of our banks. Out of the Euro we would see some actual benefit from this process – we could institute a State bank and issue non-interest bearing loans top down. Fractional reserve theft could be banned as the single most important contribution to maintaining the value of any new currency.

Within the Euro we stand to lose all of our advantages. The true nature of the linkage to the Deutsche Euro has finally dawned on most people. The Euro is a deeply flawed currency. The advantages of our participation in Euro-zone have been illusory. We should move on. This will be an issue in the upcoming General Election.

Link to a couple of bond/stock/money market extracts from newsletters one US and one Dutch (GEAB n0. 50) the ” link to chart” at bottom leads to well done charts.
The purpose of these is usually to keep the churn going but it does provide insight into what professionals consider to be a plausible scenario.

Contagion risk by country, Ireland is low which is to be expected. The sell off in muni bond funds is significant particularly if it is an early warning indicator of state and national funding problems.

The problems are global and will be resolved at the G8 and G20 level in a sane and rational world.

Mokabaybob is right. The Portuguese bond auction was fixed. Barry Eichengreen posits two possible routes for Germany. First is to let us and Greece restructure our debt. But this will mean losses realised in German banks, which will have to be re-financed by german taxpayers. Or the EU can allow us to renegotiate the terms of the bail out (lower interest rates) and to provide such funds at a very high – possibly unlimited – quantity, to, well, to Spain essentially.
Both options represent a transfer from the core (or germany) to the Periphery.
I still think that it is very important that Germany and other “core” members are not allowed to think that this is for them to decide alone. We really need to build a diplomatic offensive that will garner support from the nationsd stricken already and all those that could folow. The difficulty that – just as we argued we weren’t Greece (and we are not) so every other country strives to avoid being seen as part of the PIGS, PIIGS, PIBIGS or whatever.
Maybe we do need Bertie! (Only kidding)

I agree with you Mr. McHale that it would have to be primary market purchases. I suspect, though, (as I’m sure you do) that it is the secondary market that will be targeted. The idea will be to provide the effect of the Fed’s trillion dollar bullet, though on a typically European tuppence ha’penny.

The yield today on the US 30 year was 4.5% having been under 4% for part of the year. The 30-year bund is at 3.5% (despite the difference between Fed and ECB headline rates).

These are the sort of rates that are sustainable over a thirty year timespan. That is what is going to get the existing debt money off the eurozone’s back – long-term cheap issuance. And on the back of that for the state, the same is going to be required for variable rate consumer debt and probably for large amounts of investor debt – long-term cheap refinancing at fixed rates.

The can has to be kicked so far into the future that even at 2% max inflation it will be possible for for much of it to be paid off in those 30 years.

Ireland and Spain, as variable rate debt countries (i.e. mortgage debt) are a couple of rates rises away from a second crunch.

In the meantime, governments will have to move more quickly to live within their means…

@Rafa hijo
“Mokabaybob is right. The Portuguese bond auction was fixed.”
Bond auctions are always fixed. They don’t happen in the hope that someone will turn up and make a bid…

No kidding? Still there can be varying levels of preparation for an auction – especially when there are powerful interests concerned about the result.
The amounts were small and the resultant headlines were most welcome.
Do you think the assessment of Portugal has changed?

@ Mokabaybob

“The Fed purchased over Euro1 billion of Portugal’s last bond”

Eh, wasn’t the most recent auction only for 1.25bn in total, so it seems unlikely (i’m being polite) that the Fed would buy 90% of it or so? Relatively sure Fed purchasing was minor, if indeed anything at all. Asian central banks, Portuguese banks and Spanish banks were the far more likely buyers of it.

Is this not just a ploy to provide some ‘official’ funding at rates somewhat lower than the relatively penal rate Ireland is paying? And a means to kick the can of the requirement for some debt restructuring further down the road?

The EU’s Grand Panjandrums (both political and institutional) are doing a version of the Jack Lynch ‘soft-shoe shuffle’ – two steps forward, three steps side-ways and one step back. We’re in the end-game and they’ll have to move their positions quite a bit, so it makes sense to start throwing a few shapes now and the core EZ voters might start to be softened up enough to endure the pain that inevitably will be imposed.

This is a bit weird:
The Asian funds lend money to the fund at 2%, the fund lends to Ireland at 5%.
The difference in interest rate is to cover default risk. If the fund guaranteed peripheral bond purchases the risk premium would drop to about 2% for the peripheral bonds. In this way, as long as confidence remained in the fund peripheral bond yields would be greatly reduced and nobody would need to draw down on the fund at all?
Not sure but is this a better way than the fund buying the bonds?

@Rafa hijo
“Still there can be varying levels of preparation for an auction”
There are indeed, the Germans are particularly casual (easy to do when you have a steady stream of buyers).

And you are right, it doesn’t change the portugese position at all.

It seems like a very nice way of getting core taxpayers to give more money to periphery countries at low interest rates.

If, a big if, the problem is a liquidity problem then it might be a useful ploy to – excuse the phrase – calm the markets.

If, a big if, the periphery has a solvency problem then it’ll be a political disaster when the core taxpayer realises they’ve been ripped off. They didn’t want to lend any more money to these countries but their govts forced them to. Dangerous waters.

Meantime, Irish borrowing is still being spend in support of Croke Park, etc. and

..and countries like Spain are still sitting on a social bomb where unemployment is high, the labour market is rigid, salaries are low and where housing prices for anything even half decent within an hour of a city require unfeasible mortgages.

I love Spain, but if I was a German taxpayer I wouldn’t regard it as a risk free bet.

Sorry bout previous post – writing on an iPhone is tricky.
Is it out of the question that the EFSF would be used as a backstop for sovereign bonds – a guarantor for them. It would work like the infamous bank guarantee but would be backed up by real muscle. Any such policy would require greater oversight by Europe of how the money is spent by the peripherals. But it has many advantages.

Syndications will remain the litmus test of the success of issuance programmes. Syndications require substantial “real money” involvement. Investors however prefer to buy bonds whose prices are not above market clearing levels. Yet the past week saw more intervention from the ECB, and uncertainty as to what is to come. Does official buying of this kind, if it remains sustained, help attract investors into syndications? No one wants to buy a bond at an above-market price. Rather a functioning market (very much in the public interest) requires, at a minimum, a greater level of transparency.

That could be achieved, for example, by commitment from the ECB (or the EFSF) to buy a certain amount of bonds over a certain period. Such a scheme would be hugely supportive. That is how the ECB managed its covered bond purchase programme. That is what the Fed and the BoE have done. The difference is very simple: investors know better what to expect. The proviso of subordination of investors’ holdings remains, however.

This line of reasoning would appear quite simple. Why then is it so difficult for the European authorities to understand it? The authorities may be well meaning. But that does not suffice. They may have oodles of cash to throw at the problems Europe faces. But that does little good if market equilibria cannot be found, on the back of far healthier public finances. If the authorities want investors to trade at prices that are above market clearing levels, the result is very simple. There is no market.

For many years now, the distribution of government bonds in Europe has appeared complicated to non-Europeans (and non-specialists). Now, more than ever, there is a need for transparency. A solution to the current difficulties needs steps towards transparency in distribution, not away from it.

Liquidity provision, either to the EFSF by investors (there will be good buying of the first EFSF issue) or by the EFSF to the countries in receipt of loans, is not a long term solution to the problems that the eurozone is facing. Granted, it may boost sentiment in the near term.
@ Mokabaybob, Rafa hijo –The comment from Bond. Eoin Bond… might help you elucidate how auctions etc work. Indeed the ECB / ESCB are banned by treaty from buying in primary.
More generally, it might be of interest to note too that the EFSF is structured such that it needs some reserves, which will be in bonds, if not much at the start of its issuance (if you can invest the time, take a look at the EFSF website). We did however see that the ESCB’s bond purchases – just before Christmas – had a massive impact (if fleeting) on secondary market levels. As Joe McHale might say, some of the devil is in the detail. But coming clean on the total commitment helps transparency too.

@ Paul Hunt oh were this to be “the end-game”.. Like I said above, market equilibria need to be found, on the back of far healthier public finances.

Thank for the article John I write on these issues frequently and wanted to add some ideas to the debate if I may.

If we look where we stand right now we have the European Central Bank supporting various government bond markets via its Securities Markets Programme. This has announced some 74 billion Euros of purchases and I believe it was fairly active last week particularly in Portugal in addition to this.

The problem is that this is a tactic and not a strategy. It is something that should have lasted for a month or two not the nine it has. It should have held the line whilst a strategy was constructed. If you like that is part of a central banks role to respond to a crisis in the shorter-term whilst a full plan is developed.

The consequence of it is that it has allowed Europe’s politicians to dither and we still have no strategy in place. Another is that it questions the position of the ECB itself. If you analyse the ECB’s purchases it must have losses greater than its capital so its own position can now be questioned. Also if you look at Greece and Ireland their bond markets have not improved if anything they have got worse.Also we have the issue of at times the ECB in effect being the market which if it was done by anyone else would be called a false market.

So if we look at this flawed plan and replace it with the EFSF we have essentially the same problems. Many of the problems highlighted above would be made worse not better by expanding the EFSF. Also the EFSF has a flaw in that to deploy funds it has to borrow it and so it would be entering into the same debt markets that individual countries borrow in. What if the crisis grew and the EFSF struggled to borrow?

So my contention is that unless you intend to create an entirely false market any bond buying plan is a tactic and not a strategy…

Ecb buying can be QE if they don’t soak up elsewhere. Printing like that would have an effect on the market – but also the concept of what the euro is!

Efsf using its funds to buy is just an alternative mechanism – there still wouldn’t be funds there to take all the piigs out of the markets (in effect) for 3 yrs. They could put more funds in but they could do that anyway if the germans will pay for it.

Without theoretically unlimited ECB buying / depreciation, you have the same problem. If a sov has become a one way market effectively, the buying just provides an exit for stuffed longs. The effect Eoin mentions only works with sovs that are not yet in that position.

@Hugh Sheehy
It seems like a very nice way of getting core taxpayers to give more money to periphery countries at low interest rates.

Liquidity or solvency it is going to mean a transfer from the “core”(read German taxpayers) to the periphery. either they will subsidise our loans or they will re-finance their banks. That is basically the decision they have to make. I just think that the periphery should get organised to have a say in which way the penny falls – and how the “blame” is apportioned in the public mind.

@Ciaran O’Hagan,

Completely agree. My view is that the sovereign bond market is pricing in a huge risk, probably damn nigh a certainty, that the impairment of the peripherals’s ability to service sovereign debt will lead to default – and huge uncertainty about the potential extent of impairment in other countries. Some market players will obviously make a lot of money it things go totally t1ts up, but investors of ‘good money’ just want an end to the nonsense that is being purveyed by the EU’s Grand Panjandrums in an attempt to suspend disbelief. But the Grand Panjandrums are relying on the reluctance of most players in the sovereign bond market to force a meltdown. This kind of ‘phoney war’ can’t last forever.

I am not farmer bashing. Let’s take the example of the family who creamed 400M out of the illusion, a family who probably think that pigs can fly. I have no problem with them cashing in, even the wife of a Labour Party leader does not look a gift horse in the mouth.

The 400M is very real but the people who paid it had borrowed it from a bank and can’t pay up, the bank borrowed it from depositors and bondholders and it too can’t pay up. It would be nice to think that one could target the foreign element of that last constituency. A case of having your bubble and bursting it. The windfall winners keep their loot and foreigners lick their losses. That is not the real world.

It is equally unreal to expect the generality of taxpayers to pay for the bubble windfalls of a few. The payment for this should as far as possible and within the constitution (probably amended) be targetted at the winners. I have in mind a Bubble Tax of 80% not a mere backdating of 28% CGT.

A bit shocked to learn that Karl Marx agrees with me, maybe that guy is not as bad as the media would have you believe.

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