Irish Bonds no longer ‘junk’. What does this mean?

Celebrations in Ireland as the credit ratings agencies no longer regard Irish government debt as ‘junk’, according to the BBC. What does this mean and why does it matter? Here are some bond market reminders and links, helping to explain how governments borrow, and at what cost.

A bond is a promise to pay, or an IOU. It’s the main mechanism by which governments and large corporations borrow huge sums. This is how the UK government is financing its fiscal deficit. And there is a vast market for this debt. A crisis of confidence in this market sparked the panic that lead to the infamous 2008 ‘Credit Crunch’ when the whole market for debt temporarily seized up. The market works by having those institutions with spare cash buying lOUs from organisations that want to sell ‘paper’ to finance their current needs. There’s a bit of maths with this one, and what follows is very simplified, but it might help your understanding of debt and government finance a bit.

In this very simple example, I (the Irish Government) offer to sell you a piece of paper that promises to pay €10m a year for 10 years. At the end of that time, I also promise to buy the IOU back off you. In the meantime you can sell it to someone else, if you wish.

What will you pay me for this promise? In mid-2011, the promise could be bought for about €67m. Think about that for a moment – the Irish government gets €67m, at a price of €10m a year. In other words, the Irish government was borrowing money at over 15% rate of interest. That’s known as the yield on the bond.

The good news for Ireland is that confidence has been restored in its economy, to some extent. The same promise (to pay €10m a year for 10 years) now sells for €286m. That huge increase in price means that the Irish government is effectively borrowing at a 3.5% rate of interest, or yield. Their bonds are no longer classed as junk. A huge relief for Ireland, making their government’s debts cheaper to finance.

A reminder here of what happened to France when it lost its AAA bond rating. The effect you would predict is that the price of French government bonds would fall, and yields (interest rates) rise. And here's a blog from 2012 about UK government bonds, the yields on which you can track here.