Why US bonds matter to global markets and you

[October 16, 2013]  NEW YORK (AP) -- It's no surprise that investors get nervous every time politicians debate raising the U.S. debt limit.

The stock market is the better-known barometer of the U.S. financial system, symbolized by famous companies and colorful traders on the floor of the New York Stock Exchange. But the $38 trillion bond market is a far larger and more important driver of world financial markets.

And at the center of it all: the market for U.S. Treasurys. Treasurys play a crucial role in the global economy. They allow the U.S. to borrow cheaply to pay its bills and influence rates on home mortgages and many other kinds of loans.

Q: What are U.S. Treasurys and why do investors care about them?

A: Treasurys are debt issued by the U.S. government.

The federal government has consistently run a budget deficit for decades, so the United States borrows billions of dollars from investors to pay its bills. It borrows by selling debt in regular auctions. Those auctions are handled by the U.S. Department of the Treasury, hence the name "Treasurys."

The United States is the largest debtor on the planet, owing roughly $12 trillion to public investors.

Treasurys have different maturities, or the length of time before the debt must be repaid. The debt with the shortest maturity is the four-week Treasury bill, also called the one-month T-bill. Debt with longest maturity is the 30-year Treasury bond. Other maturities include 5- and 10-year Treasury notes, or T-notes.

Investors buy Treasurys for various reasons, but the main reason is safety. The U.S. government has never intentionally failed to pay its debts, so investors consider U.S. debt the safest, and most reliable in times of uncertainty. That debt is held by a variety of investors, including the governments of Japan and China, the largest U.S. creditors.

Treasurys are denominated in U.S. dollars, the main currency used by central banks and major financial institutions around the world. Because the U.S. government owes so much and because investors expect the U.S. government to honor its debts always, the Treasury market is considered the cornerstone of the global financial system.

Q: The "cornerstone of the global financial system?" That seems a bit excessive, don't you think?

A: It's not excessive at all.

Investors weight risk in deciding what to invest in and for how long. Risk determines how much they should be paid for placing their trust in an investment. Risk, in other words, is simply the chance that an investment will not pan out as expected.

Investors treat U.S. Treasurys as a sort of "zero point" that all other investments are calculated against. Even when a solid company like Apple issued debt to pay its bills, Apple is considered relatively more risky than the debt of the United States.

The risks of all financial instruments in the U.S. (and many around the globe) are calculated against the risk of buying U.S. Treasurys. This includes mortgages, bank rates, credit card interest rates, other bonds, etc.

In normal times, the biggest risk to U.S. Treasurys is that inflation could erase any return an investor would make, not that the government could fail to repay its debt.

Q: What's been going on with U.S. Treasurys since the debt ceiling debate turned nasty?

A: Investors have been selling Treasurys that come due around the time the U.S. government hits the debt ceiling, Oct. 17. The fear is that if the U.S. government is unable to borrow and runs out of cash, it might fail to pay back the money if owes, at least temporarily. Most Treasurys that come due in this window are one-month Treasury bills, debt issued in September that comes due in mid-to-late October.

Typically, one-month T-bills give their holders little-to-no return on their investment. For example, the U.S. government auctioned $35 billion in one-month T-bills in mid-September that had a yield of zero -- meaning investors were locking up their money with the U.S. government for a month and getting nothing for it. Because they're issued for a short period of time and are considered extremely safe, the reward for the risk is low.

However, because those mid-September bills come due in mid-October, the yield, or compensation, that investors are demanding has shot up. For the one-month Treasury bill, it went as high as 0.35 percent earlier this month.

Investors fear they might get stuck holding these T-bills and when they come due, the U.S. government won't have the cash to pay them back. At 0.35 percent, these investments are still considered safe, but it's startling to see investors lose that much confidence in one type of U.S. government investment so quickly.

Q: Are all investors nervous?

A: No. While bond investors are nervous about the short term, yields for Treasurys that take 10, 20 or 30 years to mature have remained stable during the debt fight. It is a sign that investors are confident U.S. lawmakers can come up with a plan to keep the federal government paying its debts over the long term. The yield on the benchmark U.S. 10-year Treasury note, for example, was 2.71 percent in early trading Tuesday, roughly where it was in mid-September when Wall Street began to worry about a shutdown and default.

Q: If the United States were to default, how could it affect me?

A: The biggest threat is that the government would soon fail to make interest payments on its debt. Any missed payment would trigger a default. Financial markets would sink. Social Security checks would be delayed. Eventually, the economy would almost surely slip into another financial crisis and recession.

A default could also translate into higher borrowing costs for consumers, on everything from auto to home loans. Why? Investors would consider U.S. debt a riskier investment and demand more compensation. Bond yields would likely rise, pushing interest rates higher on loans whose rates are linked to U.S. Treasurys, which is basically everything. It would make borrowing for the U.S. government more expensive, and cost us more as taxpayers. How much bond yields could rise is unknown.

There's also a strong possibility that a U.S. default may impact bank-to-bank lending.

Banks often use Treasurys as collateral when they borrow from other banks. This "repo" market is massive, roughly $5 trillion by some estimates, and is used by nearly every bank to fund day-to-day lending. Signs have emerged that some banks and money market funds have stopped accepting U.S. Treasurys as collateral, or are requiring more collateral to borrow.

That has started to affect lending. The overnight repo rate on bank loans has risen from 0.04 percent at the beginning of the month to 0.12 percent last Wednesday.

If bank lending rates go up, and if banks have to offer more collateral to borrow, it could slow lending and hurt economic growth.

[Associated Press; By KEN SWEET]

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