Understanding Government Bonds: How They Work & Why They Matter

[00:00:00]governments are currently pumping a lot of money into the economy amid panics on the stock markets I've seen a lot of people in a lot of places suggest that they are simply printing this money but this has not quite been how governments have been raising money in recent years instead they've been issuing bonds in this video I'm going to explain how this process works exactly what is a government bond traditionally they work like this the government needs to raise money for some project let's say building a bridge or funding a war in Ireland and so asks investors for a loan this is a fixed-term agreement for the government to pay back the money in a certain amount of time one year five years ten years and so on plus an agreed annual rate of interest so let's pretend it was 1,000 pounds over five years at three percent Interest I'd get my 1,000 pounds back in five years time plus 30 pounds a year giving me a grand return of one thousand one hundred and fifty pounds and why would I do this well traditionally it's been a hedge against inflation much like gold has been seen for example the annual inflation rate in the UK is two point five five percent so if I just put this thousand pound in the bank I would have lost a certain amount of money it would only be worth eight hundred and seventy two pounds in five years time so by investing in the bond the money has maintained its value and perhaps even made a little bit more on top of that and this has always been viewed as a very safe investment because the UK government is not going to Welsh on its agreement and it's practically unthinkable for an advanced economy like the UK to go bankrupt so it's an extremely low risk investment in exchange for putting your money into a safe form now to make matters more confusing in the real world these fixed term agreements come with a variety of different names in the UK they're also known as guilts in America they are known as US Treasury securities which are also called bills bonds or notes depending on the time frame and the specifics of the agreement but to keep things very simple in this video I'm just going to call all such investments government bonds as a generic name now since the 2008 financial crisis whenever they have needed more money rather than simply printing it which causes fairly rapid inflation instead governments have issued bonds here investment banks and asset management firms acting on behalf of their clients which very likely includes you by the way if you have a pension by bonds in exchange for cash the government then takes this money and does one of two things with it either number one it uses it to pay its own employees or number two it hands it to the central bank who in turn passed let out to all the private banks to issue as loan money actually in reality the money starts with the central bank and never actually makes it to the government in order to be handed back to them so actually we can turn this arrow around but anyway these are the two mechanisms by which the government can increase the total money in circulation in the real economy but because the money was taken from banks and investment management firms in the first place it has technically speaking not increased the total money supply all that has happened is that we have taken the money from the balance sheets of financial firms and reallocated it to the real economy that's you and me getting paid and buying stuff in the shops now this will result in inflation of course and there will still be Kantian effects whereby the first receivers of the money benefit to the detriment of those who act last typically savers but these inflationary effects are suppressed by the fact that the money has not simply been printed out of thin air however this strategy has started to see some limits for example remember I talked about buying a five-year bond with 3% interest as a hedge against inflation well in the real world a five-year UK bond currently yields only nought 0.52% my one thousand pound bond would earn me only 5 pounds 20 year giving me a grand total of 1026 pounds in five years time so with inflation at 2.5% this is only very marginally better than just sticking the money in the bank and worse than most ice savings accounts to make matters even worse at the moment many other government bonds are negative for example a five-year German government bond is currently at minus naught point six six percent which means for my one thousand pounds I'd actually lose six pounds sixty every year giving me a yield of minus thirty-three pounds in other words investing in this bond is actively worse than inflation so how can this possibly be and why given such conditions would anyone ever buy these bonds they're not doing the one thing they were meant to do for the traditional investor namely hedging against inflation well the answer lies in a set of regulations brought in after 2008 known as Basel 3 now back when I'd spend all day talking to people in investment banks and wealth management firms back in 2010 when it was my job this was all anyone was talking about all day every day the specific part that concerns us is something called hqla or high-quality liquidity assets this is effectively a mandate for financial firms to keep their assets in a certain configuration the thinking was that after 2008 they don't want a situation where too many of the assets of these firms are high risk or low quality like those notorious toxic debt bundles that you heard so much about now there's a lot of information here and I will not bore you by getting into the weeds but the heart of the mandate is that certain assets are kept gold for example is counted as a level 2b asset which are capped at 15% of the bank's total stock banks essentially have a quota which says that no more than 15% of their assets can be of this type and then within that the portfolio has to be diverse so they could not hold 100% of their level to be allocation as gold it would have to be mixed in with whatever else count just to be in any case while many assets are capped in this way level one assets are entirely uncapped what counts as level one or basically only two types of asset cash or bonds of various kinds and like I said within the level there is a mandate for the portfolio to be mixed so financial firms are basically required by law to hold various kinds of government bonds so what happened is that because these financial firms max out on their allowances at the level to be level two a and so on they are left with no choice but to hold a huge amount of government bonds you might call it a captive market whereby governments effectively forced the financial sector to buy their bonds hence these very low interest rates or even negative interest rates so here you can see the balance sheet of goldman sachs from three months of 2017 and because all of the regulatory checks they have to comply with these days they have to hold around 160 billion in either cash or bonds and although they don't break down their level one asset you can be sure that a high proportion of that value will be what is effectively US government debt and here is where things get a while because on top of forcing financial firms to buy their bonds the governments have another trick up their sleeve the central bank the central bank can and also does buy bonds themselves for example this is the total number of US government bonds held by the Federal Reserve don't worry it's only about two point four trillion dollars when central banks do this their purchases are known as repos and really this is where money is printed out of thin air but typically the injection of cash is not pushed out into the real economy but remains somewhat hidden which is to say locked up in the asset portfolio or for example a pension fund just as cash and not as a bond again this will obviously have an inflationary effect but now it's delayed until such time as the money is paid out to the individual pension holder what happens to the bonds do government still pay interest do you on their more the final principle payments to the central bank's well all this is somewhat mysterious and as far as I can see it all disappears into voodoo to make matters even more confusing with the recent coronavirus measures central banks have started buying up other assets from financial firms not just their government bonds but also their corporate bonds their stocks their shares for example whatever else that is currently losing value on the market essentially the central banks are buying up to generate all of this money that you're seeing the thinking here is that perhaps these assets will regain value in time so the central bank which has a longer time horizon might recover that money whereas the various financial firms and the real economy beyond that need liquid assets to stay afloat right now so it's a it's a time preference thing the central bank has a longer time horizon and a lower time preference than basically anybody else in the economy so they can you know buy up all of these assets that are currently rubbish but may in time gain their value well anyway that's the theory how all this plays out in practice remains to be seen but for now everyone keep calm and stay safe now get out