The Italian Job–Understanding the Secondary Bond Market

There is an old Albanian expression that says you can’t take a swim and not get wet. In Bulgaria, the same conundrum is described as the wolf can’t be fed, and the lamb intact. The Hungarians refer to the same problem by saying, It is impossible to ride two horses with one butt. You and I may have heard of the problem described as not being able to have our cake and eat it too.

The idiom will change depending on the culture, but the meaning is the same. If the idiom was created by bondholders, the saying might go something like you can’t be both the lender and the spender. In other words, you can’t lend your savings for someone else to spend, and have it to spend yourself at the same time. Or can you? With a bit of magic, the wizards of Wall Street have been able to turn a traditional idiom on its head. By creating a secondary market for bonds, it turns out today, you can lend and spend at the same time.

When a government borrows money, they do so by selling bonds through an auction in the primary market. As a purchaser of that bond, you are transferring your savings to the government for the duration that is specified on the bond. If it were a 5-year bond, you would be giving up the use of your savings for five years in exchange for interest income. But what happens if you decide you don’t want to hold the bond for five years? You can’t just tell the government that you changed your mind and would like your money back. Is there a way you can lend, but have access to spend at the same time? Enter, the secondary market for bonds.

Once the government gets your money, it is not obligated to pay you before the due date specified on the bond. If you want your money before then, you can sell your bond on the secondary market. The secondary market is where previously issued bonds are bought and sold among investors. If you bought a 5-year bond directly from the government and decided two years later that you wanted your money back, you could sell it on the secondary market to anyone who is interested in the three remaining years of interest the bond has to offer. In theory, this allows a saver to be a lender and a spender at the same time.

Under calm market conditions, the secondary market for bonds is very liquid. Just like stocks, there is a bid and ask price listed, so you can see at any time what your bonds are worth. Usually, the market is so efficient that bonds have effectively become thought of as money that pays interest. Why leave your money in a savings or checking account at zero interest when you can earn the same interest as someone who gives up the use of their money for 5, 10, or even 30 years? If you lived and banked in Italy in the first half of 2018, you learned first hand why.

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While the stock market usually grabs the financial market headlines, it is dwarfed in both size and trading volume by the world bond markets. Not only is the bond market much more massive, but the participants are also typically more risk-averse than stock investors are. For those that don’t have the stomach for the ups and downs of the stock market, bonds are the go-to investment of choice. The liquid secondary market reinforces the view that bonds are safe, but occasionally, the bond market will remind us that a dollar in hand is not the same as a dollar owed in the future.

During May of 2018, Volere la botte piena e la moglie ubriaca (the Italian version of the old proverb) rang through Italian bondholder’s ears as they were reminded once again that their bonds were not cash after all. A look at the chart below shows what happened to the value of Italian 5-year bonds as their government struggled to form a coalition. As bondholders en masse decided maybe it wouldn’t be a bad idea to turn their bonds into cash in case the government that owes them money dissolves, the posted bids for those bonds were withdrawn.

Suddenly a liquid market with tight spreads (the difference between what you pay to buy, or get paid to sell) became illiquid, and the spreads widened dramatically. At the very time sellers decided to sell, buyers changed their mind about buying. This resulted in a collapse of prices.

For stock investors, a drop like the one shown above is something that investors learn to deal with. But remember the mindset of most bondholders. To them, government bonds are cash, with interest, plus a minor inconvenience of having to sell before spending. Imagine if your savings account dropped ten percent over a couple of weeks without you making any withdrawals. I’m guessing it would get your attention?

This isn’t the first time Italians were taught the difference between cash and bonds. In 2012, the market for Italian bonds really froze. When the Italian government found itself in trouble, buyers simply disappeared. Bond prices plummeted with such ferocity that the ECB was forced to step up and buy Italian debt on the secondary market to stave off a total collapse. Then, as now, things calmed down, and buyers re-emerged. But these tremors are reminders that when things go sideways, Vouloir le beurre et l’argent du beurre.