The Sage of Ely on the value of government debt

And Daniel had a great slide showing how much greater the market value of UK government debt is than its nominal value. The excess is about £500 billion right now – all of which has, by definition, to unwind before these debts are repaid.

Now someone who knew about financial markets would mention this to disabuse people of the notion. Market value is above nominal? Sure it is. 15 years ago we were issuing debt for 30 years at what, 5% interest rates? 10 years ago we collapsed interest rates to, effectively, 0 %. Those old bonds are therefore worth more than new ones being issued at 0%.

Their nominal value is above par, which is what is being said.

But does this have to be unwound? No, because bonds are valued on yield to maturity. I don’t think we’ve any permanent bonds left do we, didn’t they pay off all the Consols? Meaning that everyone knows that those 5% bonds are only going to pay that much until they mature, in 15 years. Then they will be replaced with new bonds – rolled over, not actually paid off that is – at whatever the interest rate is then, perhaps 0%.

Note that such bonds collapse back to par value as they mature whatever happens to the general interest rate environment around them.

OK, that’s the background, here’s the Sage of Ely:

card says:
September 15 2017 at 10:44 am
“how much greater the market value of UK government debt is than its nominal value. The excess is about £500 billion right now – all of which has, by definition, to unwind before these debts are repaid.”

Forgive the stupid question, but what’s the significance of the gap opening up between nominal and market value?

Reply
Richard Murphy says:
September 15 2017 at 10:48 am
The significance is that in pensions funds, insurance companies and banks there is a massive pile of assets valued at vastly more than they can ever actually be worth because they only ever eventually pay back their nominal value

Reply

Sigh. The value comes in two parts, doesn’t it? They get 5% interest on the par value for 15 years, not 0% interest. Both get paid back at par then. 5% interest for 15 years is worth more than 0% interest. They have a higher value because they’ll get paid more.

To make it even clearer. Liquidity issues aside – an old bond with a coupon of 5% and par of £100 with 5 years to maturity is worth more than a new 5 year bond of £100 par and 0% interest. It’s worth more by the net present value of those future income streams, £5 a year and £100 in 5 years. The new bond, of the same maturity note, pays only the £100 back. Ignoring time value therefore the old bond has a capital value £25 higher than the new one. A value that is going to disappear as the old bond moves to par value as maturity gets closer.

We would expect our old bond to be trading at £125, well above par therefore. The Sage is saying that £25 will never be paid to the holder. I insist that it’s worth more because the £25 will be paid to the holder.

Now think on this. One of the two of us is nominally a professor of some form of economics at a UK university. And it’s not me, me with the right answer now, is it?

And he’s really, really, not getting it, is he?

Paul Smith says:
September 15 2017 at 12:03 pm
I agree with your general hypothesis that there’s going to be a crash soon (after all it’s 10 years since the last one so it’s time for it), and it may be fairly devastating, mainly because the economy is in a much worse state than it was last time, and, of course, the impact of Brexit.

However I don’t follow your argument re the gap between the market and nominal values of government debt. This arises because we have much lower interest rates now than we did at the time most of this debt was issued. So the gap represents the capital losses that have already been incurred by the holders of the bonds, not as something that has to be repaid in the future. What it does mean is that the government now has relatively expensive debts on which it is paying interest above the current rates.

Reply
Richard Murphy says:
September 15 2017 at 12:32 pm
I am baffled

How have you made a capital loss when the asset has risen in price, because that is what has happened?

And no, the government does not have expensive debt: it has incredibly cheap debt because it only has to repay the nominal sum meaning that future capital losses are guaranteed to those buying at current prices or valuing them at these marked up rates

He’s entirely ignoring the value of the interest stream on a bond. Amazing.

27 thoughts on “The Sage of Ely on the value of government debt”

  1. “Now think on this. One of the two of us is nominally a professor of some form of economics at a UK university. And it’s not me, me with the right answer now, is it?”

    Ah, but an alternative explanation is that one of you has swallowed the dogma of conventional economics and one of you invented a completely new set of economic rules, unconstrained by blinkered conditioning from study of the neoliberal courses on economics on offer at Uni at the time(Southampton in this particular case).

  2. He has previously shown he doesn’t understand NPVs (he said “the cash flows are literally ignored in the valuation”). Turns out that he is the one literally ignoring them.

    He is a bottomless well of stupidity. Eventually we won’t have a rope long enough to pull out the bucket of dribble.

  3. Murphy is not real is he? Tim invented him so a kind if Socratic dialogue could take place to enable the wider public to get an understanding of rudimentary economics. If that is not true then it’s all too depressing.

  4. He’s entirely ignoring the value of the interest stream on a bond

    99.9% of the population are. The difference with Spud is that he thinks he is an expert.

  5. He cannot have overlooked the fact that bonds (like any investment) have a capital and a dividend.

    He must be just expressing himself poorly. Does par and coupon confuse him? Those are (somewhat) terms of art. Perhaps he’s unfamiliar with the exact words or is trying to simplify for a lay audience.

    Either that, or he’s seriously unwell. Doesn’t a stroke do this? Knock out bits of someone’s knowledge, leaving other bits unaffected?

  6. it has incredibly cheap debt because it only has to repay the nominal sum

    Spud, through his own efforts, is an outstanding salient in the broad panorama of human stupidity.

    Not only is he ignoring the stream of payments during the life of the bond, he’s apparently unaware that the nominal sum is what was raised by the bond in the first place.

    I wonder if that poor libelled fellow at the BoE follows TRUK.

  7. Also: Lol at how Murphy just outright denies P Smith’s (who he?) point that debt is relatively more expensive now.

  8. The thing is, the tragedy, is that Professor Daniel Mugge also believes this nonsense. That’s 2 professors of economics in the same room, displaying total ignorance of bond valuations. You’d get more sense from strolling up to a couple of pigs and tickling them

  9. Very few people understand how bonds are priced and sold. Even the 5% is not really 5% – sure the coupon is fixed for 15 years but the interest rate this yields the purchaser depends wholly on the price to buy that coupon.

    Look at Greece. They’ll issue ‘E50bn’ of bonds. And they’ll have to repay E50bn of principal at the end (or not as the case may be). But they’ll not get E50bn for the bonds they sell with that face value. Cox it’s junk. They’ll get about E30bn.

    Interest rates for bonds are determined not by the fixed payments they offer but by the price they trade at.

    Please could someone tell the ignorant this is how they work.

  10. Except those high asset values will get marked down – as they get closer to redemption, the value will tend towards nominal and the pension fund will have to mark this value down. If the pension fund holds to maturity, they will recoup this decline in the book value by – almost precisely exactly – the above-market-rate interest payment, but there will be a hit to book value.

    So he’s right about that, but just not for the right reason.

  11. I’m really very sure that bonds to be held to redemption are going to be valued at redemption values, not market…..

  12. Doesn’t the fall in value happen in stages every six months? The day after the government pays the next slug of interest, the bond value drops.

    (other changes happen at any time, as market interest rates change, etc., but even if nothing else happens there’s staged falls in the capital value)

  13. @ Tim Worstall
    If an investing institution buys a fixed-interest investment and declares that it shall be held to maturity it should value that investment at the dcf value of future receipts using the discount rate calculated on the purchase price – which is a long-winded version of saying that you are, mostly, right. However if the investment is held as “available for sale” it will be valued at market price.

  14. “future capital losses are guaranteed to those buying at current prices”

    There’s his problem. He’s a tax accountant (in so far as he has any professional skills), so he’s too hung up on the capital v revenue distinction.

    Interest payments on the bond are income, so he puts them in a completely different box to the capital, because that’s what tax law does, and he can’t see that to the investor they’re both parts of the overall return.

  15. He’s doubling down in his comments.

    When did a provincial accountant working on the relatively simple tax affairs of some actors become an expert on insurance company and pension scheme solvency assessment? They are quite complicated topics and I’ve spent my entire working life on them and I wouldn’t be making such confident assertions as he does. He seems quite sure of himself.

  16. All I know is from what I’ve read on the wiki article on bonds and even I can tell Murphy is arse about face.

  17. He’s far too busy reading every email & listening to every phone call to identify which director of an ISP or Telco should be imprisoned for abetting crime to be bothered with facts on this issue. (see the ‘abetting’ thread on TRUK)

  18. @Diogenes, September 15, 2017 at 3:27 pm

    …You’d get more sense from strolling up to a couple of pigs and tickling them

    Longrider, is Dio correct based on your experience with training pigs to sing?

  19. Poor Sap:

    Richard,

    You mentioned spreadsheets in one of your earlier replies so I thought it would be enlightening and helpful to try something out.

    Assume the following:
    Current interest rate is 0.5%
    Gilt has a nominal value of £100 and redemption is in ten years
    Coupon is 5% payable annually.

    Question:
    What is the value today of this bond?

    Method:
    enter the following into cell A1
    =NPV(0.005,5,5,5,5,5,5,5,5,5,105)

    This gives a present or market value of £143.79 or more than 40% above nominal value.

    Would you agree with my workings?

    Spud: But you’re assuming a shock free world and it does not exist

  20. Forgive me if I have got this wrong (and please correct me gently but firmly when I have) but…

    We (the consumer/taxpayer) have to pay £500 beellion in interest over the next 15 years in interest alone and then have to stump up the redemption value of the bonds.

    Perhaps Tim can explain why we are borrowing from the market at Wonga rates when We own an issuing bank and a mint.
    As the UK borrows in Sterling, is this a method of tying up chunks of the currency for long periods ?

  21. I remember some 35 years ago my father showing me in the financial pages of the Telegraph how bond prices returned to coupon value as maturity approached. That was back in the day when there were 13% Treasuries to be had.

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