Q&A: Bonds and eurobonds
Governments auction bonds to raise funds
The idea of eurozone economies clubbing together to issue bonds representing all 17 member nations has been gathering momentum.
And it has some pretty influential backers. For example, billionaire investor George Soros has said the bonds could be a good way to reduce the borrowing costs of highly-indebted nations, while Italian Finance Minister Giulio Tremonti has described them as the "master solution" to the debt crisis.
Now the president of the European Commission, Jose Manuel Barroso, has said he will formally propose the idea to the European heads of government.
But those that really matter are less keen.
The German government has said eurobonds "don't make sense" right now, given that individual member states conduct their own economic policies. It is also concerned the introduction of such bonds could reduce the resolve of highly-indebted governments to balance their budgets.
But what are eurobonds, and government bonds on which they are based (just remember of course that eurobonds don't actually exist at the moment)?
What is a government bond?
Governments borrow money by selling securities known as bonds to investors. In return for the investor's cash, the government promises to pay a fixed rate of interest over a specific period - say 4% every year for 10 years. At the end of the period, the investor is repaid the cash they originally paid, cancelling that particular bit of government debt. Government bonds have traditionally been seen as ultra-safe long-term investments and are held by pension funds, insurance companies and banks, as well as private investors. They are a vital way for countries to raise funds.
So what is a eurobond?
A eurobond would operate in exactly the same way as a government bond, except that all 17 member states of the eurozone would collectively guarantee the debt rather than a single government.
What is a bond market?
Once a bond has been issued - and the government has the cash - the investor can hold it and collect the interest every year until it is repayable. But investors can also sell the bond on the financial markets. The price of the bond will fluctuate as the outlook for interest rates changes. So, for example, if the markets think that interest rates are going to rise sharply, then the value of a bond paying a fixed rate of 4% for the next 10 years will fall. Bond prices will also fall if investors think that there is a risk of the government that issued the bond not being able to make the annual interest payment or repay it in full on maturity - and these are the fears which have been pushing down Irish bond prices.
What is a bond yield?
This sounds complicated, but isn't! The yield is the return received by an investor who buys the bond at today's market price. Let's take an example. A bond is sold by a government for 100 euros, paying an annual interest rate of 4%, or 4 euros per year. The yield is 4%. But then the market price of the bond falls to 50 euros. The interest payment (the coupon) is still 4 euros per year. So for a 50 euro investment the investor can get a 4 euro annual payment, which is a return or "yield" of 8%. Market commentators usually quote bond yields, rather than prices. The key thing to remember is that bad news drives down bond prices, which pushes up bond yields.
Why do bond markets matter?
Because they determine what it costs a government to borrow. When a government wants to raise new money it issues new bonds. But those bonds have to pay an annual interest rate which is close to the current yield for bonds which it has issued earlier and are now being traded in the market (see above). So if a crisis of confidence drives up market yields the government has to pay more for new borrowings - possibly a lot more. (But remember that it does not affect the cost of paying the annual interest of existing bonds, because the interest rate is fixed for the life of the bond).
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