Europe’s bond markets, explained

LONDON, United Kingdom — "The bond markets don't like this, the bond markets don't like that."

As the euro zone's sovereign debt crisis has raced out of control in the last few months the "bond markets'" likes and dislikes have become a journalistic cliche.

But is the market for European sovereign debt really a monolith with a mind capable of liking or disliking anything? 

In fact, it's a bit more complicated than that.

Here is a GlobalPost primer on what used to be a rather dull backwater of finance, but has now become the major determinant of whether the euro zone survives and the world economy tips into another major recession.

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What are they? The bond markets are a remarkably complex set of exchanges that where people buy and sell debt — essentially, they match borrowers with lenders. Each euro zone country issues its own bonds, each pays a market determined rate of interest which varies widely and changes almost every day. The sovereign bond markets trade have been evolving in real time as the euro zone nations have struggled to keep the cost of borrowing within reason.

Size: According to Standard & Poor's data, the current total redemption worth of all the euro zone's sovereign debt is 8.4 trillion euros ($11.25 trillion dollars). That is a 42 percent increase since that golden age of growth in 2005. However, S&P thinks that number will come down next year because Greece, Portugal and Ireland can no longer borrow in the markets.

The players: Who holds all that debt? "Holders are a heterogeneous group," says Richard Portes, President of the Centre for Economic Policy Research, and professor at the London Business School. "Some are there to trade, some are there to hold for the long term."

Or Raviv, fellow in European Political Economy at LSE is more specific. "Pension funds and mutual funds are obviously the biggest players in government debt markets," Raviv says. He says that sovereign debt's reputation for low default risk is what attracts them to the investment — although the current volatility in Europe is obviously harming that reputation and scaring off these funds. 

Central banks and some sovereign wealth funds also buy other nations' bonds in order to diversify their holdings.

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The third major group is banks. Raviv explains, "In the context of the current crisis from 2008 onwards, banks could borrow very cheaply at virtually 0 percent interest from central banks and park the money in … government debt yielding 2.5-3.5 percent annually thus strengthening their balance sheets." 

Who owns what? What percentage of the 8.4 trillion euros is held by pension funds, what percent is held by public entities like central banks?

This seems important information because clearly each player has different reasons for purchasing bonds at certain prices. These reasons may be in competition with each other.

But this is where things gets confusing, because no one collates this info. There is a considerable amount of opacity in European sovereign debt markets. In a paper written several years ago, Professor Portes wrote the lack of transparency served a purpose: "Some degree of opacity seems necessary to induce dealers to supply both liquidity and pre-trade information." 

A distinctive feature of the euro zone nations' bond markets is the large number of banks with cross border holdings.

For example French banks are heavily exposed to Greek debt. British banks hold a lot of Italian bonds. The idea that in the future they may be forced to accept less than their face value at maturity led to a major sell-off by banks of their euro zone bond holdings.

In November France's largest bank, BNP-Paribas, sold 11 billion euros ($14.3 billion) of Greek debt and 8 billion euros ($10.4 billion) of Italian debt. Its total loss was around 3 billion euros ($3.9 billion).

How has the crisis changed the markets? As banks got out of the market others came to play. LSE's Raviv says this has changed the situation fundamentally. "Recently there has been great risk aversion. The big institutions have gone. Instead you have risk takers who bring volatility to the market. What you see then is high fluctuation in bond yields."

The risk takers, mostly hedge funds, speculate on short term movements of interest rates. They work the secondary bond markets where the holders of the original bond use credit default swaps to hedge risk. The speculators are very short term players. But when the usual long term players are not participating in the market because they are afraid that euro zone countries are going to default then it is the risk takers who set the price of a bond.

Portes sees things differently. What he calls "short horizon" players bring liquidity into the market because of the high volume of trades they make. This does not necessarily raise volatility, he says, adding, "The issue is trend, not volatility. The daily and hourly movements of the market are volatile but the trend line (of a bond price) is what counts." What's the time frame for assessing a trend? "One year."

The Future: The big news this week — probably the biggest news of the last 90 days — was Wednesday's announcement by the European Central Bank that it was opening lines of credit for euro zone retail banks. The banks can borrow money for three years at 1 percent interest.

This was an offer the retail banks could not refuse. More than 500 banks, most of them from the most indebted euro zone countries borrowed about 489 billion euros ($638 billion) within hours of the ECB announcement.

Governments know how they want the banks to spend the money. So does Wall Street Journal blogger Nicholas Hastings, "There is no debate. There is no option. European banks have to start buying euro-zone sovereign bonds now. If they don’t, the banks will not only be putting the euro zone in peril but they will be putting their own futures at stake."

It isn't clear whether the banks will use the money that way. Some may simply want to park the cash on their balance sheets against future losses as many countries in the euro zone flirt with a double-dip recession in 2012. But it is a reasonable guess that over the Christmas holiday the heads of the euro zone's big retail banks will be getting a lot of phone calls from the Prime Ministers and Presidents of the euro zone countries urging them to return to the bond markets.