Who’s buying US bonds?
Let us start off simple. A bond is an instrument used by institutions(governments, companies, etc) to raise money. This is similar to a loan but in this case, the money is raised from the public or other institutions. As a loan has an interest rate so do these bonds and they are called coupon rates. The coupon rates depend on the company’s credit ratings provided by companies such as Moody’s, S&P, and CRISIL. If the company is at risk of default then a higher coupon rate is attached to the bond to account for the risk.
Coming to US bonds, or Treasury bonds.
Treasury bonds (T-bonds) are government debt securities issued by the U.S. Federal government that have maturities of 20 or 30 years. T-bonds earn periodic interest until maturity, at which point the owner is also paid a par amount equal to the principal.
Treasury bonds are part of the larger category of U.S. sovereign debt known collectively as Treasuries, which are typically regarded as virtually risk-free since they are backed by the U.S. government’s ability to tax its citizens.
Now coming to the relationship between yields, coupon rates and bond prices. The yields and coupon rates start out the same at the time of the bond issue. The coupon rates are fixed whereas the yields and bond prices fluctuate. This means if the principal(Face value) on the bond is $100 and the coupon rate is 2%, this implies every year the bondholder gets $2. This remains constant till maturity. In the case when the interest rate increases the bond pays a lower interest compared to what you could get if you invested the same amount in a bond with the current interest rate as the coupon rate. Naturally, the price of the bond decreases.
Now that we are done with introductions, let's get into the meaty portion.
Let us start by looking at the total US bonds owned by foreign investors over the years followed by holding split up by countries.
So we see that the US bond holdings have increased from 2011–2022. However, there has been a steep drop in 2022. This coincides with the rising interest rates in the US. We can also observe the main players in the US bond market are Japan, China, the UK, Belgium and Luxembourg. Coming to the country-wise split over the years.
From these graphs, we can observe the general sell-off trend of US bonds outside of Belgium, which is consistent with the trend we observed earlier. China and Japan have had sizable reductions in their US bond holding through the years.
The main point I’m trying to get at is who is going to buy the older US bonds with lower coupon rates compared to the newer ones issued? Who is buying the bonds that these countries are selling? What is the impact of a mass sell-off by say China? Will China hold the US in a hostage situation given the rising tensions between both countries?
We know that as the coupon rate increases the price of the bond increases. This begs the question, what happens to the older bonds, for example, 10-year bonds issued 5 years ago, with lower coupon rates compared to the current interest rates? One could argue that those bonds could be held to maturity. However, investors who do this are basically getting wiped out by inflation and below-par results. Say an investor invested in a 10-year US bond with a 2% coupon rate 4 years back. The interest rates now are 5%. So for 1, the investor loses on the extra interest payouts and 2, the bond price depreciates. Investors would naturally try to get rid of these investments, but the question is who is buying?
Moving on to the countries, the Fed and China were a couple of the largest holders of US bonds. The Fed bought bonds to stabilise the US economy post-2008 (quantitative easing) and China bought bonds during their boom period to stabilise their country. We are dealing with the excess money printing and floating in the US economy now via higher and stickier interest rates. Whereas, in the case of China it is going through one of the worst housing market collapses in its history. Many builders are on the verge of bankruptcy and the debt to GDP rose to dangerous levels of 282%. This impending/ongoing crash is frightening FIIs who are pulling out of Chinese markets and thus de-stabilising the Yuan. To remedy this China might be selling its US bonds for liquidity.
So the big question remains who is going to buy these older bonds? Say the banks are forced to buy back these bonds or the price of these long-tenured bonds drops below the principal amount. In the first case, yes banks have the ability to hold till maturity, but that also means that they’ll be sacrificing their profits on illiquid assets(at least for the time being). If you’d like to argue the 2nd case where you’d get bonds at lower prices than the principal amount attached to it, another question arises — until when do you wait to earn back your principal 7,13,15,20yrs…? Yes, you would get your interest payments on a yearly basis, but then again these are much less than the interest you’d get on rates today. Which again becomes another illiquid asset in your portfolio.
To add to this, let’s just look at the situation the US government is in after its recent debt ceiling stand-off
Fitch Ratings — London — 01 Aug 2023: Fitch Ratings has downgraded the United States of America’s Long-Term Foreign-Currency Issuer Default Rating (IDR) to ‘AA+’ from ‘AAA’. The Rating Watch Negative was removed and a Stable Outlook assigned. The Country Ceiling has been affirmed at ‘AAA’.
Ratings Downgrade: The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to ‘AA’ and ‘AAA’ rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions.
These last-minute resolutions indicate 1 thing for certain, the US government is facing a liquidity crisis.
It also doesn’t help that U.S. is running a high deficit. The federal budget deficit was $1.7 trillion in fiscal year 2023, Congressional Budget Office estimated on Oct. 10. That’s higher than the. $1.38 trillion recorded last year.
So what happens to the bonds that are due in the coming few years? These bonds are mostly the bonds that the government had issued before the tightening and thus the interest payments on these are negligible compared to today. So yes, these bonds will mostly be paid back in full either via the taxpayer’s money or by issuing more bonds. However, due to the higher interest rates, their cost of funds/borrowing just went up. Thus, a fresh issue of bonds now is akin to kicking the can down for later.
Investors may not consider the 30-year the best predictor of bond market’s demand given its long duration but the Treasury also saw a weak auction recently for the 10-year and three year Treasuries. That suggests there are fewer takers on government debt across various points on the curve.
The messaging on weak demand comes as ‘term premium,’ a theoretical value that reflects the amount of extra yield investors are demanding to hold a 10-year Treasury, a long-term debt, hit a positive value for the first time since June 2021 late last month. It’s the compensation that investors demand for the risks of holding a long-term bond rather than continuing to roll over short-term debt. Those risks include changes in monetary policy or unexpected inflation that could alter the value of a long-term bond.
This leads to another situation. The bondholders are fresh from the experience of viewing the depreciating bond prices. This combined with the uncertainty of increasing interest rates would make them hesitant to bid for a fresh issue of bonds in today’s market. With the lack of demand, bond prices are going to fall and to hedge against this, investors are looking for better yields to hold on to the bonds.
The U.S. government has issued $15.73 trillion in Treasuries through September, up from $12.53 trillion in the year-ago period. Higher supplies tend to push prices down and yields up.
So putting all this into perspective. Traditionally US bonds were considered safe havens. However, in an inflationary scenario if you hold bonds to maturity you are most likely to lose money. Many investors realise this and look to sell out but alas again because of inflation and thus higher interest rates, the older bonds are priced far less than what they paid for them. Again they lose money. Moreover, the trend as we see it is the lack of demand for US bonds and the increasing scare of US defaulting on bond commitments. So coming back to the question, Who’s buying US bonds? This I feel is a question that currently doesn’t have an answer and is only going to grow larger and larger from this point on. What I mean by this is more people and institutions are going to be asking themselves this question as we slowly creep away from the US dollar as a reserve currency.
PS Latest development: This article from Yahoo highlights the same issues!
