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Turning up the heat on bond investors

December 5, 2010 | 12:57 pm

When companies go bankrupt, their bondholders rarely expect to get back all of what they’re owed. They end up sharing the pain.

Germany and France want owners of government bonds in Europe to face the same risk.

After approving a euro-zone bailout of Ireland a week ago -- six months after bailing out Greece -- European finance ministers drew a line in the sand: Acceding to German and French demands, they agreed that private bondholders of euro-zone countries could be forced to sacrifice some of their interest or principal on any restructurings of sovereign debt issued after July 2013.

"Restructure," of course, is just a polite way of saying "default."

History is filled with episodes of sovereign countries defaulting on their debts, but as I note in my weekend column in The Times, it would have been unthinkable even two years ago that a euro-zone nation could go that route.

Yet the crushing debt loads of many developed countries and their states and municipalities have forced investors to reconsider the risks of owning those entities’ bonds. The surge in market interest rates on bonds of Spain and Italy this year shows the new level of concern about countries which, in U.S. banking parlance, used to be considered "too big to fail."

And what about the U.S., the biggest debtor of all?

The idea of the U.S. Treasury defaulting on its debt still is unthinkable. As long as we can print more dollars to pay off creditors (including China) -- and as long as they’ll accept those dollars -- the risk of actual default is near zero.

But as I note in the column, what really should concern most bond owners is the risk of de facto default: Historically, the easy way for governments to cure a debt problem has been for them to stoke inflation, which is good for debtors -- and ruinous for creditors, because they’re paid back in devalued dollars.

Or if market interest rates rise because of higher inflation or because investors perceive a country to be sliding into a deeper fiscal hole, owners of older fixed-rate debt will automatically see the market value of their bonds drop. That's how a lot of investors have lost money on European sovereign debt this year (at least on paper), even though no euro-zone country has actually defaulted.

Here's how the column begins:

When President Obama's deficit-reduction commission this week unveiled its proposals to bring the government's mushrooming debt under control, it cited the necessity of "shared sacrifice." In other words, pain all around.

One group, however, wasn't asked to sacrifice anything: the people and institutions to whom the debt is owed.

The idea that America will pay its creditors 100% of what they were promised is a bulwark of the global financial system, of course. Nobody would seriously expect the deficit commission to suggest that Washington should consider an alternative approach.

Yet as countries and their states and municipalities worldwide face up to the bitter reality of deleveraging -- working down the mountain of debt and pledged entitlements built up over the last 30 years -- bondholders increasingly may find themselves with targets on their backs.

Read the rest of it here.

-- Tom Petruno

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