What does it mean if the "debt bubble" bursts?

Can anyone explain this to me, please?

I am wondering about this in terms of investments v. cash savings? But am also generally curious. A poster raised this issue in a recent thread.

Thanks.
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  • bowlhead99
    bowlhead99 Posts: 12,295
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    edited 19 June 2017 at 11:21PM
    What does it mean if the "debt bubble" bursts?
    Can anyone explain this to me, please?

    I am wondering about this in terms of investments v. cash savings? But am also generally curious. A poster raised this issue in a recent thread
    I'll have a go..

    With interest rates so low for so long, companies and governments that want to issue debt (borrow money from investors) can do so at very low rates of interest. This makes tradeable bonds very expensive. For example:

    A decade ago if a company or government issued a very long term bond they might say the bond costs £100 and will pay out £6 interest a year for the next few decades before finally maturing and paying you back the £100. So as an investor paying £100 for the bond (whether directly to the company for a newly issued bond, or buying it second-hand from someone on the market) you were getting 6% a year on what you'd just paid over for it.

    You wouldn't bother too much about the £100 because you don't get that back for ages, by which time it might not be worth much in real terms, but the £6 per year (6%) is the return you are collecting year in year out as interest on your investment. If the company is creditworthy there's a risk they might go bust but hopefully not a large one so this is a long term £6 per year income stream.

    Now imagine the bank base rates and market interest rates all fall dramatically. The company or government issuing new bonds doesn't need to offer to pay as much interest on them as they did before, because nobody is paying high rates of interest on debts if they are financially strong. So they might issue new bonds at £100 paying only £3 a year interest (3% on what the bond costs).

    Imagine you have one of the first bonds paying £6 per year for the next few decades from a company or government that's equally as creditworthy as the company or government that's now only paying £3 interest a year on the £100 debt/loan/ bond...

    How much would someone pay you to take that special "high paying, £6 per year" bond off your hands? You wouldn't let it go for only the £100 you'd originally paid for it, you'd want more. And they wouldn't expect to be able to buy it off you for only £100 when it pays £6 a year and the market interest rate for that sort of bond is about 3%. Instead they might be willing to pay you up to £200 for the bond, because then they'd be getting 3% (£6 a year) on what they just spent.

    Now what happens if rates fall further (or stay low for longer), so people are desperate for a safe-haven investment that pays a good return? Everyone is falling over themselves to buy your bond that only has £100 face value for a lot more than £100 or £200. The bonds go up in value while ​the yields (effective interest rates) go down.

    So if you have been invested in long term bonds, or bond funds, the have been some serious gains being made over the last decade, not just from the interest being paid out by the companies and governments on the debt they borrowed but also from market participants such as yourself who can buy a bond at £100, pick up some interest receipts *and* later sell at £200. Or buy at £150 or £200 and sell for £300 while still taking a few years worth of income along the way.

    Obviously, this can't go on forever. At some point, the bond will mature and stop paying interest and simply return the £100 originally loaned to the company. If you just paid £400 to buy that bond, it's a big loss. Or perhaps the market interest rates will go up higher and higher so that the bonds paying only £3 or £6 a year costing £100 or £200 or £300 are not attractive at all, compared to buying a newly issued bond paying £8 per year for only a £100 cost.

    The people stuck holding a long term bond with a low interest rate are going to find that bond is worth perhaps a great deal less on the open market than they paid for it. Unless the maturity date is soon, they might just want to dump it for the best price they can get that day.

    So, buying some types of bonds in 2017 might be an expensive mistake if the bond pricing bubble bursts and we all go back to sensible pricing.

    In the US for example, the Fed is raising rates and will start to sell bonds in the market instead of buying them. That's not great for the value of US treasury bonds (sometimes considered a safe haven) which will fall in value as the interest rates go up and the US banks try to slim down their reserves of other bank or government or investment-grade corporate bonds (which are only paying a tiny return) in favour of lending to consumers and other businesses as the economy gets stronger. They may turn out not to be a safe haven at all if lots of people are clamouring to sell bonds.

    But of course the strength of the equity and bond markets, how much they keep going up or how much they fall or the shape of the next financial crisis, will depend on exactly what happens next in the world economy and in different countries and industries. We can't see the future. We can just comment that some types of bonds will do better or worse than others depending on what happens next.

    If you look at some types of bonds in some countries including our own, the bonds are so expensive that the yield to maturity (the total of interest payments you'll get plus the capital value at the end) is virtually guaranteed to be negative, or may be negative in real terms. Why would anyone buy them at such prices?

    Well, some big institutions with billions to deploy into the equity and bond markets will still buy them because being guaranteed to only lose a bit of your investment value is safer than maybe losing half or two thirds of your investment on the equities markets.

    In some parts of the world bonds have now settled back a bit lower than their old high prices because they expect (for example) US interest rates will rise three or four times this year, and people don't want to hold old bonds when the yields are getting better and better on new bonds being issued or that might be issued soon. In other parts of the world where the equity markets aren't going up so fast, or interest rates aren't rising, and inflation is low, there may be more sense in holding bonds - so the prices are still very high. And if there's an equities crash, people want to hold something safe, and depending on the reason for the equities crash, certain types of bonds might be really great to hold while it happens.

    But to make a long story short (though too late for that really :D), basically if you are considering cash versus "very low risk" investments, be aware that some types of low risk investments could fall considerably in a bonds crash while not really offering any better rates of interest than a good savings account. Perversely you may be able to get a better risk/reward tradeoff in some cases by opting to buy traditionally "higher risk" investments with some natural inflation protection or long term growth prospects, or just by not investing at all and staying in cash with a top rated consumer best-buy bank account.

    That's ​not to say "avoid bonds" but just recognise that it is not just "cash vs equities vs property vs bonds ; bonds go all the way from 1 to 8 on a risk scale of 1-10 and there are different types offering different things and different prospects across different economic and market conditions. If you are building a portfolio by allocating assets yourself, you need to consider the likelihood of crashes and bubbles bursting etc etc across all of the things you're considering buying.
  • Glen_Clark
    Glen_Clark Posts: 4,397 Forumite
    edited 20 June 2017 at 7:22AM
    bowlhead99 wrote: »
    I'll have a go..

    With interest rates so low for so long, companies and governments that want to issue debt (borrow money from investors) can do so at very low rates of interest. This makes tradeable bonds very expensive. For example:

    A decade ago if a company or government issued a very long term bond they might say the bond costs £100 and will pay out £6 interest a year for the next few decades before finally maturing and paying you back the £100. So as an investor paying £100 for the bond (whether directly to the company for a newly issued bond, or buying it second-hand from someone on the market) you were getting 6% a year on what you'd just paid over for it.

    You wouldn't bother too much about the £100 because you don't get that back for ages, by which time it might not be worth much in real terms, but the £6 per year (6%) is the return you are collecting year in year out as interest on your investment. If the company is creditworthy there's a risk they might go bust but hopefully not a large one so this is a long term £6 per year income stream.

    Now imagine the bank base rates and market interest rates all fall dramatically. The company or government issuing new bonds doesn't need to offer to pay as much interest on them as they did before, because nobody is paying high rates of interest on debts if they are financially strong. So they might issue new bonds at £100 paying only £3 a year interest (3% on what the bond costs).

    Imagine you have one of the first bonds paying £6 per year for the next few decades from a company or government that's equally as creditworthy as the company or government that's now only paying £3 interest a year on the £100 debt/loan/ bond...

    How much would someone pay you to take that special "high paying, £6 per year" bond off your hands? You wouldn't let it go for only the £100 you'd originally paid for it, you'd want more. And they wouldn't expect to be able to buy it off you for only £100 when it pays £6 a year and the market interest rate for that sort of bond is about 3%. Instead they might be willing to pay you up to £200 for the bond, because then they'd be getting 3% (£6 a year) on what they just spent.

    Now what happens if rates fall further (or stay low for longer), so people are desperate for a safe-haven investment that pays a good return? Everyone is falling over themselves to buy your bond that only has £100 face value for a lot more than £100 or £200. The bonds go up in value while ​the yields (effective interest rates) go down.

    So if you have been invested in long term bonds, or bond funds, the have been some serious gains being made over the last decade, not just from the interest being paid out by the companies and governments on the debt they borrowed but also from market participants such as yourself who can buy a bond at £100, pick up some interest receipts *and* later sell at £200. Or buy at £150 or £200 and sell for £300 while still taking a few years worth of income along the way.

    Obviously, this can't go on forever. At some point, the bond will mature and stop paying interest and simply return the £100 originally loaned to the company. If you just paid £400 to buy that bond, it's a big loss. Or perhaps the market interest rates will go up higher and higher so that the bonds paying only £3 or £6 a year costing £100 or £200 or £300 are not attractive at all, compared to buying a newly issued bond paying £8 per year for only a £100 cost.

    The people stuck holding a long term bond with a low interest rate are going to find that bond is worth perhaps a great deal less on the open market than they paid for it. Unless the maturity date is soon, they might just want to dump it for the best price they can get that day.

    So, buying some types of bonds in 2017 might be an expensive mistake if the bond pricing bubble bursts and we all go back to sensible pricing.

    In the US for example, the Fed is raising rates and will start to sell bonds in the market instead of buying them. That's not great for the value of US treasury bonds (sometimes considered a safe haven) which will fall in value as the interest rates go up and the US banks try to slim down their reserves of other bank or government or investment-grade corporate bonds (which are only paying a tiny return) in favour of lending to consumers and other businesses as the economy gets stronger. They may turn out not to be a safe haven at all if lots of people are clamouring to sell bonds.

    But of course the strength of the equity and bond markets, how much they keep going up or how much they fall or the shape of the next financial crisis, will depend on exactly what happens next in the world economy and in different countries and industries. We can't see the future. We can just comment that some types of bonds will do better or worse than others depending on what happens next.

    If you look at some types of bonds in some countries including our own, the bonds are so expensive that the yield to maturity (the total of interest payments you'll get plus the capital value at the end) is virtually guaranteed to be negative, or may be negative in real terms. Why would anyone buy them at such prices?

    Well, some big institutions with billions to deploy into the equity and bond markets will still buy them because being guaranteed to only lose a bit of your investment value is safer than maybe losing half or two thirds of your investment on the equities markets.

    In some parts of the world bonds have now settled back a bit lower than their old high prices because they expect (for example) US interest rates will rise three or four times this year, and people don't want to hold old bonds when the yields are getting better and better on new bonds being issued or that might be issued soon. In other parts of the world where the equity markets aren't going up so fast, or interest rates aren't rising, and inflation is low, there may be more sense in holding bonds - so the prices are still very high. And if there's an equities crash, people want to hold something safe, and depending on the reason for the equities crash, certain types of bonds might be really great to hold while it happens.

    But to make a long story short (though too late for that really :D), basically if you are considering cash versus "very low risk" investments, be aware that some types of low risk investments could fall considerably in a bonds crash while not really offering any better rates of interest than a good savings account. Perversely you may be able to get a better risk/reward tradeoff in some cases by opting to buy traditionally "higher risk" investments with some natural inflation protection or long term growth prospects, or just by not investing at all and staying in cash with a top rated consumer best-buy bank account.

    That's ​not to say "avoid bonds" but just recognise that it is not just "cash vs equities vs property vs bonds ; bonds go all the way from 1 to 8 on a risk scale of 1-10 and there are different types offering different things and different prospects across different economic and market conditions. If you are building a portfolio by allocating assets yourself, you need to consider the likelihood of crashes and bubbles bursting etc etc across all of the things you're considering buying.

    Great post which I have asked to be made into a sticky.
    It would be a waste for it to sink off the front page and disappear among the trash.
    “It is difficult to get a man to understand something, when his salary depends on his not understanding it.” --Upton Sinclair
  • IceTry
    IceTry Posts: 27
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    edited 20 June 2017 at 2:19PM
    Richey_ wrote: »
    It was raised in your recent thread

    http://forums.moneysavingexpert.com/showthread.php?p=72719375

    Why start a new forum thread and not just continue your last one?

    The reason I started a new thread was because my question wasn't answered in previous thread - I believe it simply got lost on page 1, as sometimes happens on forums. I didn't quote the thread either because I didn't think it was relevant and I didn't want to waste people's time reading irrelevant stuff! However, if it helps to give the context of my question of my thread it was about where to put life savings. I hope that answers your question.

    Although I did not receive a response, I found the original comment (by CarrieAnne I believe) intriguing enough to dig further for a response on the Forum, if necessary as a whole new topic on its own.

    I now have a nice strong cup of coffee in my hands and am going to look at Bowlhead99's reply - I really appreciate him taking the time to answer. If its helpful to others too, even better:).
  • bowlhead99
    bowlhead99 Posts: 12,295
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    IceTry wrote: »
    I now have a nice strong cup of coffee in my hands and am going to look at Glen Clark's reply - I really appreciate him taking the time to answer. If its helpful to others too, even better:).

    Yeah, he's a helpful chap that Glen Clark, when he lays off the politics :D
  • Glen_Clark
    Glen_Clark Posts: 4,397 Forumite
    bowlhead99 wrote: »
    when he lays off the politics :D

    But Politics is whats driving markets - to the extent that BlackRock pays £700k a year to hire G Osborne. I only wonder how much they would pay for a politician whose predictions have been right, (but then I suppose a good one might not be for hire.)
    “It is difficult to get a man to understand something, when his salary depends on his not understanding it.” --Upton Sinclair
  • badger09
    badger09 Posts: 11,105
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    IceTry wrote: »


    I now have a nice strong cup of coffee in my hands and am going to look at Glen Clark's reply - I really appreciate him taking the time to answer. If its helpful to others too, even better:).

    I think you mean bowlhead99's reply.

    Glen's don't usually run to 18 paragraphs;)
  • Sticky :)


    (Not enough characters so I'm making more up as I go along) :D
    Could you do with a Money Makeover?


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  • IceTry
    IceTry Posts: 27
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    Oops yes, I meant Bowlhead99, amended!
  • Generally it means people are unable to repay their debts usually due to a rise or series of rises in interest rates. Then you get house and asset repossessions, then lenders are unwilling to lend, house prices and shares plunge. Can be accompanied by high inflation. In that scenario, best to own some gold like in the credit crunch.
  • DiggerUK
    DiggerUK Posts: 4,992
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    That was the original question.
    The debt bubble that burst in 2007 came about for the age old reason, credit was abundant, cheap and easily available. Leveraged financial activity was the name of the game.
    It's all fine 'n dandy when the debt can be serviced, but when the liquidity dries up......well, we all know what happened recently.

    It will be the same this time. Government debt will be a problem, but going forward that debt won't be the main problem. Just part of it.

    This is a review by the LBMA Alchemist of "Saving the City" from Prof. Richard Roberts, a book I highly recommend.
    http://www.lbma.org.uk/assets/blog/alchemist_articles/Alch73Roberts.pdf
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