I explain what bonds are, what exactly is happening in this market and what the government’s problems with financing the deficit may lead to. Here’s everything you need to know about the bond market in Poland.
Bonds are financial instruments that connect entities that want to incur debt with investors who are looking to invest their capital. In recent months, an unprecedented sell-off has swept through the bond market, which means losses for investors and the prospect of an increase in debt financing costs for the government
According to economists, in order to improve the situation, the government should fight inflation and improve budget discipline
The Ministry of Finance has a growing problem with obtaining financing on the markets – according to unofficial information obtained by Business Insider Polska . After a few years in which the government enjoyed a good budget and had no problems with increasing spending, this could mean a complete reversal of the situation .
The fact that the situation on the Treasury bond market is becoming more and more difficult will affect every Pole. That is why we explain what bonds are, what exactly is happening in this market and what the government’s problems with financing the deficit may lead to. Here’s everything you need to know about the bond market.
What are bonds and what role do they play?
Bonds are financial instruments that connect entities that want to incur debt with investors who are looking to invest their capital . In this way, companies can finance investments and governments can spend expenses in a similar way as consumers can buy an apartment or a car with a bank loan.
The issuer of the bonds states that he owes the bondholder (i.e. the person who buys the bonds) a debt. It undertakes to pay interest and capital on a predetermined date and under certain conditions (if it fails to do so, it can be called insolvency). From the investors’ point of view, bonds are a safer – but also less profitable – investment than stocks .
All because they give the right to interest, but not to a part of the profits achieved by companies (bondholders also have a smaller possibility of influencing how the issuer of bonds spends the money entrusted by them, compared to shareholders). When a company is doing well, bondholders benefit less from shareholders. However, when a company goes bankrupt, the reverse is true – their claims are satisfied first.
What are the types and what is their yield?
If the issuer of the bonds is an enterprise, then we are talking about corporate bonds, and if the government – then about treasury bonds . Unlike corporate bonds, most government securities have a fixed coupon – payable regardless of future inflation and interest rates.
This means that the government knows the interest rate on the related “loan” at the moment of issuing the bond. However, market conditions change rapidly, and this represents a gain or a loss for bondholders. If the NBP interest rates rise (or investors expect such an increase), this translates into an increase in the profitability of Polish treasury bonds.
Such an increase in yields is bad news for bondholders, as it is usually accompanied by a fall in bond prices . It may not be intuitive, but in fact the principle is simple. If fixed coupons are paid on the bonds and profitability rises, buyers are paying lower and lower prices for them. It is imperative that the difference between the purchase cost and the price of a later purchase by the State provide them with an additional profit over and above that resulting from the amount of the coupon (that is, the higher profitability).
How does the government sell bonds and how are they traded?
As Przemysław Kwiecień, chief economist of the brokerage company X-Trade Brokers, explains, the government borrows by organising bond auctions . Banks take part in them, but only those that are dealers of Treasury securities. Bonds issued in this way can later be sold to other investors on the so-called secondary market .
“The interbank market plays this role. Treasury dealers have the most say there, but also funds and foreign investors are important players. Bonds are also traded on the WSE, thanks to which individual investors can buy them”, says Przemysław Kwiecień.
As the specialist adds, the interbank market is much larger. Both are interrelated due to arbitrage, i.e. price equalisation by investors specialising in finding their small deviations in order to make a profit on them. However, investors who buy bonds on a regulated stock market must take into account that the spread between the bid and ask prices is larger, and the bids are small. Therefore, big investors mostly stick to the unregulated interbank market.
Is buying bonds safe? What are the risk factors?
As Przemysław Kwiecień from X-Trade Brokers notes, the main risk factor for bond investors is the interest rate risk . If the cost of money has to be raised (most often it is due to inflation), it has a negative effect on the debt market. Another risk factor is that something bad will happen to the issuer.
“It’s about situations such as insolvency or war . They mean huge losses for investors, but fortunately their probability is relatively low from a historical point of view” notes Przemysław Kwiecień.
The last type of risk is liquidity risk – which is best seen in the example of bonds listed on the Warsaw Stock Exchange. If there are few offers on the market, it may happen that the investor is forced to sell them at a very unfavourable price. However, it is usually most important to remember that bond prices are closely related to interest rates, and the greater the impact, the longer the maturity of the securities is.
“People think bonds are safe and therefore often put themselves at risks they do not understand . The risk associated with bonds is of a different nature to that associated with stocks, but it is still a risk”, reminds the chief economist of X-Trade Brokers.
How has the Polish bond market been behaving recently?
Here we come to the heart of the matter, because it is the behaviour of the Polish bond market that has become a problem for the government in recent months. Since the bottom in early 2021, yields have gone up by about 5 percentage points, which is a sell-off that has no precedent after 1989. On Tuesday, investors wanted to lend to the government for 10 years at an interest rate not lower than 6.1 percent. (temporarily, the profitability was as high as 6.27 percent).
This translated into a collapse in the prices of these securities by about 30% within a dozen or so months, which is not uncommon in the case of stocks, but in the bond market it practically only happens in the event of the issuer’s insolvency. Investors last demanded an equally high interest rate at the beginning of this week in November 2011. This means that in just over a year the yields jumped as much as they fell in over 9 years earlier .
For comparison – of course, bearing in mind other reasons for both phenomena – it is worth recalling that a similar jump in profitability as in Poland took place in Greece on the eve of the debt crisis a decade ago . Then the yields jumped by about 6 percentage points within 13 months, exceeding 10%.
Did all bond investors lose?
While severe losses had to be borne by virtually all banks and foreign institutions investing in Polish Treasury bonds, the situation in the case of Polish individual investors is very diverse . This is because they were able to invest in retail bonds.
“Inflation-indexed bonds are the most popular among retail bonds. For investors who had these securities, the situation on the bond market with a fixed interest rate does not matter” explains Przemysław Kwiecień from X-Trade Brokers.
As the specialist adds, inflation-indexed securities were actually a hedge against what happened to most bonds (it should be remembered that retail bonds licensed by PKO BP can only be resold to a dealer under pre-determined conditions, which is why they are not listed on the stock exchange). Losses concern those investors who bought units in debt funds .
“The vast majority of the bonds in their portfolios are fixed interest rate securities, the treasury of which has issued the most. Only a few funds of Polish treasury bonds were able to limit their losses – those investing in bonds with variable interest rates or those with short maturities” , notes Przemysław Kwiecień.
Why are there fewer and fewer people willing to buy Polish bonds?
According to Przemysław Kwiecień from X-Trade Brokers, the current sell-off of bonds is mainly due to inflation and concerns that high interest rates will stay with us for longer . Too lax fiscal policy, i.e. too high government spending with simultaneous tax cuts, also has a significant impact. This was combined with the situation in the global bond markets .
“These factors are interrelated. The increase in yields on the main bond markets in the world results from the global increase in inflation and the expectations that central banks will counter it by raising interest rates”, explains Przemysław Kwiecień.
There are indications that the government’s borrowing needs will continue to grow. All thanks to the financing costs of the so-called anti-inflationary shields , which, according to economists, do not solve the causes of inflation, but only postpone its peak intensity to a later date, and because of plans to increase defence spending and help refugees.
At the same time , the government lowers taxes, and the continuing dispute with the EU over the rule of law postpones the prospect of unblocking the funds belonging to Poland from the KPO . Meanwhile, the scale of the global sell-off of bonds is shown by the increase in the yields of 10-year securities in the US. Compared to the low from two years ago, it is 2.3 percentage points. – that’s a lot, but much less than in Poland.
Why is the rise in bond yields a problem?
The government has problems finding financing in the market. This is hardly surprising as investors are increasingly reluctant to lend to him. The increase in profitability means that the government will be forced to refinance the existing debt on worse conditions as long as the elevated yields persist. If the market situation does not change, the result may be a permanent increase in the cost of public debt servicing.
At the same time, it may be even more difficult for the government to obtain financing if investors find that the planned gap between budget revenues and expenses is too great. Then , yields may reach an excessive level, forcing the government to save and change its policy aimed at long-term counteracting inflation .
We are already dealing with the first such signals. During the Local Government Financial Congress, the chief economist of the Ministry of Finance admitted that there would be “some restraint” on the side of fiscal policy. Łukasz Czernicki explained during the panel hosted by Business Insider Polska that the argument for this is the necessity to counteract inflation.
What should the government do in this situation, and why has it not been so far?
According to Przemysław Kwiecień, in order to enjoy low financing costs, the government should pursue a sensible fiscal policy in the long term . First of all, it must not raise concerns about the debt slipping out of control. At the same time, the central bank should take care of money stability. If a country fails to do so, it may be penalised by investors.
“This is the situation we are dealing with now, when among the turbulence in the bond markets, the securities of the countries with the weakest foundations are the most sold-off “ notes the chief economist of X-Trade Brokers.
However, so far the government was not inclined to save , which was probably due to the low cost of financing, which it could enjoy until the first half of 2021. In some cases, the new budget expenditures were aimed at securing the government’s support for specific social groups. According to Karol Paczuski, with whom Business Insider Polska spoke in March , the parliamentary elections planned for 2023 create an exceptionally strong incentive for the government not to introduce savings for the time being .
Does only Poland have this type of problem?
Other countries are also struggling with the problem of growing profitability. As Przemysław Kwiecień notes, in Hungary inflation increased the cost of debt almost as much as in Poland , and the scale of this move in the Czech Republic is only slightly smaller. Countries with higher indebtedness can have a big problem. In Italy or Spain, the yields did not go up as much as in Poland, but of course such a scenario cannot be ruled out.
“If the profitability in these countries reached the levels already observed in Poland , then due to the higher debt, the burden of its servicing could prove difficult to bear” , notes the chief economist of X-Trade Brokers.
More and more countries in the world have problems with debt service, although so far the scale of fears is much smaller than during the crisis in the euro area of 2012. The good economic situation last year meant that no country went bankrupt, but in 2020 such Lebanon, Argentina, Belize, Zambia and Suriname were fateful.
In recent days, Sri Lanka , which has had economic problems for years, and the COVID-19 pandemic, has led to a collapse in tourism there, informed about the inability to pay interest. Russia, which is subject to international sanctions, is also on the verge of insolvency.