Bonds: helpful in the short term, potentially dangerous
The U.S. government has been acquiring bonds since the beginning to stay afloat despite an ever-increasing national debt. Even though debt is not preferred, it finances public goods and services — making it potentially disastrous that ten-year treasury bond return is collapsing in value.
As securities that hold some market value, bonds allow governments to get short-term cash in exchange for paying interest. Ten-year treasury bonds are the prime mechanism for financing what debt the government has. They are the primary tool allowing the governments of the world to function.
There are three main parts of bonds: the face value, the maturity and the coupon rate. The face value is the amount of the loan, the maturity is how long until the principle amount is restored and the coupon rate is the percent of the principle that will be paid out periodically.
For example, say the government offered the following bond: $1,000 face value, 5-year maturity with a 5 percent coupon rate, that pays out annually.
Depending on the market price of the bond — the amount paid for the bond, not the face value — you will purchase it. You would then be paid five percent of $1,000, $50, every year for five years.
At the end of the fifth year, you would be paid $1,050, in total. You would take home $1,250, or $250 in profit, after five years.
Even though a company or government is almost guaranteed a loss, they still sell them because they want to generate quick cash. When a bond is sold, the company or government immediately gets a cash injection, hoping that it will generate growth to surpass the cost of the future payments.
The economy may be headed into another 2008-like recession, where people will continually invest in a low-risk government bond despite a spectacular low return, causing bond inflation and a collapse of the bonds. However, Japan, the United States and the United Kingdom have historically in-depth and credible central banks, making this unlikely.
Due to the scale of bond purchases high inflation may arise, but this has yet to occur. With the economy continuing to perform below potential, consumer confidence would likely not lead to a “bond bubble” bursting.
A bubble is when there is a rush to invest in something, causing its price to remain above its fair market price. Slowly, people realize this inflation and pull out. The credibility of the U.S. Federal Reserve, gained by keeping inflation near target and raising the interest rate to curb run-away spending, will likely carry us through the bond bubble.
These factors ensure treasury bonds avoid inflation and collapse, but the further impacts of a bond bubble could result in the worst recessions ever.
If the United States’ bond values sunk and people eventually stopped purchasing U.S. bonds, that could mean an incredible decline in government works. The United States has sold trillions in bonds over the years , making a potential bond collapse particularly calamitous.
Avoiding this issue is tricky. It could force the Unites States to cut back on spending through the financing of debt in the form of bonds, which might mean a short-term recession.
Columnist Cameron Barrett is an economics senior and can be reached at [email protected]