So, the claim is that there’s uncertainty in the market, not just risk, who in buggery knows what’s going to happen and so he’s right!
At which point he says this:
And the only thing we know about that new reality is that gilts will be redeemed at par, which means that the only rational valuation in the face of discontinuity is something not too far from that value. But right now we are far from it. And I’d suggest that makes the current premium looks decidedly uncomfortable.
No, he’s still not getting it at all.
The original observation was, recall:
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.
Well, what is the cause of that valuation above par? That a goodly chunk of the gilts in issue were issued when base rates were substantially higher than they are now. They thus carry coupons substantially higher than those newly issued. Those newly issued trade at around par, of course. Those with a decade or more to run at a higher than yield coupon obviously trade above par, so that their yields are comparable to other gilts. The amount they do so being a function of that gap between the coupon and market yield and the time to maturity.
As examples, and only examples of the maths, if current yields are at 0%, and we have two bonds both of 10 years remaining maturity, one at a 5% coupon and one at 10%, then the 5% will trade at half the premium to par as the 10% one. That’s to ignore NPV of course but that only changes the numbers, not the basic logic.
This has nothing at all to do with risk or uncertainty. As long as we agree that gilts are going to get paid their coupon and principal on time – which the Senior Lecturer does, specifically – then this price difference is going to remain. Bonds with coupons above market yield will be valued above par, that above par valuation collapsing as they receive their interest payments over time and come closer to maturity.
This is nothing to do with salt or fresh water economics, laissez faire or New Keynesianism, nothing at all to do with risk or uncertainty. It’s the simple maths of the bond markets.
Run through the maths yourself. We have two bonds in issue, again just examples.
Newly issued 5 year bond with coupon of 0% (just to keep the math easy) when market yield is 0%. The only payment anyone will receive from this is the par value, £100. If interest rates really are zero then this is worth £100.
OK, We’ve also a 30 year bond with 5 years left to maturity with a coupon of 5%. That is going to pay the £100 par value at the same time as the first bond, so whatever value we ascribe to that principal is going to be exactly the same. But it is also going to pay out £25 in interest, £5 each year.
We really do generally think that £125 is worth more than £100. Our credit risk is exactly the same here, our estimations of risk and uncertainty exactly the same. And we really do think that £125 is worth more than £100. Thus the second bond trades at a premium to par, at a premium to the lower coupon bond of the same maturity.
This just isn’t some grand mistake of neoliberalism, this is just accounting – heck, it’s just arithmetic.
And remember folks, it’s the Senior Lecturer who teaches economics in the British University, not me.
Ask yourself this question. Can you think of any way, any way at all, where a bond with a 5% coupon is not worth more than one with a 0% coupon? Note that both bonds have the same maturity date, are from the same issuer, have exactly the same terms and conditions, the only difference is their coupon.
One further question – how far up yourself do you have to be to insist that you’ve not made a booboo but instead it is the rest of the world’s neoliberalism to blame?
(I would also recommend the comments over there. He’s not a happy bunny)