The Return of the Bond Vigilantes – Overview of the sovereign bond market and negotiations around the Greek debt restructuring
ITUC/TUAC Paper prepared by Pierre Habbard



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Executive summary and key messages

Bond Vigilantes are those speculators that make a short term profit out of threatening governments that are highly vulnerable to the bond markets. And as the global economic crisis has turned into a sovereign debt crisis in Europe, they are more dangerous than ever.

Total OECD public debt has increased by almost 50% since 2007, and stands at USD36tr which is twice the amount held by pension funds worldwide. The annual net increase in sovereign bond issuance has exceeded USD2tr since 2009; this is equivalent to the combined value of the Dutch and Australian pension fund industries. The cost of borrowing has increased significantly for governments as a result. But financial speculation has played its part. Loaded with public debt and with massive “contingent liabilities” arising from guarantees to the banking sector, governments have come under pressure from the bond markets and the credit rating agencies to engage in draconian austerity measures.

It would be too simplistic to portray OECD governments solely as innocent bystanders and victims, however. It is they who failed to take decisive action on the financial regulatory front. It is they who turned abruptly away from fiscal stimulus in 2010, killing the few remaining sources of growth. Meanwhile the European Central Bank (ECB) made every possible wrong choice throughout the development of the sovereign debt crisis. While it has provided unlimited lending to private banks, the ECB has denied that right to governments. And it has only reluctantly accepted that private bondholders share the burden of the debt restructuring of Greece.

The largest bond fund in the world is run by US fund manager Pimco with some USD144bn assets under management. There are thousands of bond funds worldwide, however. The largest asset managers also include US fund managers BlackRock, Vanguard and Franklin Templeton. But the majority of top asset managers are subsidiaries of international banking groups that are considered as “too-big-to-fail” by the G20 and the Financial Stability Board (Goldman Sachs, Morgan Stanley, JPMorgan, Société Générale, Deutsche Bank, UBS, HSBC, etc.) and of global insurance companies (Allianz, Prudential, AXA). Little is known however on the governance of the bond managers and their remuneration schemes, because most of them are established as private companies.

The “shadow banking” system also plays a key role in the bond market. Being excessively averse to market and credit risks, money market funds are particular exposed to herding behaviour and to the “rush to safety” which can destabilise bond markets. Hedge funds constitute a smaller group but one that is far more active. Hedge funds are reported to have intervened massively in the Greek bond market in the past year, buying bonds at a 50% discount or more. Securities lending and speculative short selling trading are also on the rise in the EU.

Hedge funds have moved in because other investors have been offloading their debt in the wake of the decisions of credit rating agencies (CRAs) to downgrade countries’ debt ratings.  The speed at which the rating agencies have downgraded the debt of Southern and Peripheral Europe cannot be explained by fundamentals. And in the process the agencies have accelerated and deepened tensions and speculation, thereby worsening the economic outlook for those economies in a vicious self-fulfilling circle. Greece fell by 15 notches in just 18 months, from ‘high quality’ rated issuer to ‘near bankruptcy’. Public concern over rating agencies goes beyond the opacity of the rating methodologies. Conflicts of interest and, in the case of the bond market, collusion with bond managers are of concern.

After lengthy negotiations the €130bn EU-IMF rescue plan for Greece first announced in October 2011 was finally agreed and settled on 20th February 2012. The deal includes a ‘voluntary’ Private Sector Involvement (PSI) entailing a 55.5% ‘haircut’ on the net present value of Greek bonds. Negotiations with private bondholders (represented by the Institute of International Finance) have been tense “with stormy exchanges” with the IMF managing director Christine Lagarde. By contrast the ECB has been reportedly siding with bondholders to protect the Euro’s “credibility” and make sure that the PSI is not replicated elsewhere while refusing to include its own bond holdings in the haircut deal.

The PSI deal needed to remain voluntary. The alternative solution of a ‘disorderly’ default of Greece would have activated billions of payouts in Greek CDS contracts. That is precisely what governments did not want to happen because it could put the entire Euro system in jeopardy. Formal default would also reward the hedge funds that have been building up massive positions in both the Greek bonds and the Greek CDS markets in the hope of winning the game no matter what happens.

So who are the new bond vigilantes? They are the hedge funds that are piling up Greek bonds at a heavy discount (as well as Portuguese, Italian, and Irish bonds) as the banks have offloaded their holdings to clean up their balance sheets. They are betting on a continuation of the EU bail outs and, if not, on the payouts they would get on the Credit Default Swap (CDS) market in case of a formal default of Greece.

What are the policy implications?

The findings of the present paper support several policy positions adopted by Global Unions in recent statements to the G20 and its Financial Stability Board.

Financial conglomerates that have become “too-big-to-fail” and are listed as such by the G20 – the “Global Systemically Important Banks” – hold excessive market power in the bond management business and in the “shadow banking” sector. That power extends to policy forums and lobbying groups which are influential in the bond market. These findings bear clear relevance to the Global Unions call for restructuring those conglomerates and shielding retail commercial banking from the speculative and volatile investment and trading activities.

Market transparency is an issue. Publicly available information on the trading houses that manage the bond funds is lacking, to say the least. This is particularly true for those investment vehicles and trading practices that are prone to short term speculation, hedge funds, derivatives trading and ownership and reporting on security lending. This paper validates trade union concerns about lax reporting and disclosure requirements that benefit private investment companies that manage the bond fund market.

Speculative trading needs to be curbed. The paper also confirms the need to substantially increase transparency in derivatives trading and to ban the ultra-speculative ‘naked CDS’ trading (i.e. buying long on a sovereign CDS and at the same time selling short on the underlying sovereign bond). In that regard, a financial transactions tax on OTC derivatives, in line with what the OECD is suggesting, would go a long way increasing transparency, lengthen the holding period of derivatives and prevent short term socially useless trading behaviour.

Regulating credit rating agencies. The European bond market is a case in point of the pro-cyclicality of credit rating agencies (flawed ratings prior to the crisis, abrupt series of downgrading afterwards) and the excessive concentration of the sector (three agencies dominate the sector). Agencies should be subject to far more transparency and reporting requirements regarding their methodologies and the way they are financed and governed.