Recent Irish bond yields explained in plain English.

We are not issuing bonds, so the cost of servicing our debt has not magically risen to ‘7%’ because we are not borrowing at that rate, what is happening is all in the secondary market.

What that means: The primary market is when the bond is first issued at par (100) and with a coupon (for instance 3%). When a bond is issued the main concern of a bond buyer is getting your capital back (that par value of 100) and it trumps the yield in terms of importance, so you regularly see people buy debt at very low rates from those most likely to pay it back, Microsoft recently issued a bond at 0.8%!

That is where the Ireland story gets interesting, our bond yield is not 7% because we issued it at that yield or interest rate, it is 7% because people are sacrificing their capital to get out of the trade. That means they don’t believe they will get their money back at the end and because of it they will take a loss today rather than carry on and potentially take a greater loss later. You also have a timing issue in which the ‘dirty price’ means you can almost break even (as if you only earned 0% interest – not bad in a world of deflation).

When you buy a bond you pay the seller their accrued interest, so if a bond pays coupon once a year (we’ll assume at 4%) and you buy half way through the year then you pay the seller 2% plus the purchase price (100) giving you a total of €102, this is just for an example. If sellers are getting out of a trade because they fear Irish debt then the accrued interest is part of the deal, and that means they might be selling at 96 but being paid 4 as part of the accrued interest and therefore they are in effect getting out of the trade having made no interest – bust most importantly – having protected their overall capital.

Ireland is being punished on the secondary market, this is newsworthy, but not reflective of definite action because we are not currently issuing any debt. The secondary market is the proxy for the primary but until next year we don’t have set prices on how much it will cost at that point to raise money.

To yield 7% it would mean that a bond yielding 3% historically would be trading at around 96.26 [103/107], because the actual interest rate isn’t changing, rather it is the capital value which is changing. It’s like a see-saw, if yields go up on one side, the prices are going down on the other, if yields are falling the capital value is rising.

The final thing affecting Ireland is the flight to safety, peripheral countries are not in vogue and because of this investors are piling into the Bund, the true benchmark. Why is it the true benchmark? Well, they don’t look at the Irish/French spread do they!

Proof of this additional problem is in the German 30yr Bund, trading c. 131! That is a near unheard of 31% appreciation in the CAPITAL value of the bond! It issued with a coupon of 4.75% but now that has been compressed down to 2.9% this shows that investors are willing to spend €31 over and above the face value to get a yield of 2.9% because they believe fully they will get every coupon payment and their €100 back at the end of the term.

In a nutshell, Ireland is facing twin dilemmas, on one hand we have a credibility crisis causing capital values to plummet and yields to rise, but on the other there is an international flight to safety (in the US it is happening on the TNotes and TIP’s markets) making everybody who isn’t Germany look less attractive, inflation would perhaps give an appetite to investors to get into riskier assets, for bond investors this could mean a return to Irish debt (they don’t often substitute with equities), and gold prices along with the likes of the previously mentioned TIP’s make a compelling case for this, the mention of QE2 – which is only one policy option there are three or four more – will perhaps create this dynamic.

For now however, our yields will not change the cost of funding our debt, its all secondary market and therefore our costs are fixed in servicing it for now – it will be the auction next year that matters, all the noise at present is merely pointing out that we could be ‘headed’ for trouble at that auction, it doesn’t mean we are already there.

Caveat as always: the interpretation of the budget and a credible turn around plan are what will make or break our efforts to avoid going to the EFSF, so for now its a wait and watch story.

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