Financial education for young people 👨🎓👩🎓
Bonds are an important asset when it comes to investing which is why the US debt ceiling crisis could have massive implications.
What's happening?
First, let's discuss bonds. A bond is essentially a loan that you as the investor makes to either a company (corporate bond) or a government🤝(government bond; the type we will be focusing on). Bonds belong to the fixed income asset class because they pay out fixed interest payments on your loan over a specific period.
Now for some quick vocabulary 🗊🤓; the ‘face value’ of the bond is the amount of the loan that the borrower will pay back the investor after a set amount of time. The date that the borrower pays the investor back is called the ‘maturity date’. And, the interest payments the investor receives are usually called ‘coupons’. It’s important to note that with bonds, the face value is the amount of the loan, but is different from the price of the bond, which can change according to market conditions and the demand for certain types of assets under those conditions.
Bonds, more specifically bonds issued by well-established governments, are an important type of asset because they are considered low-risk. Remember, a bond is essentially a loan you make to the government. The likelihood that the government will be able to repay you the face value of the loan at the maturity date and make coupon payments determines the risk; governments with a higher chance of defaulting on their loans, or failing to make these payments, will issue higher risk bonds.
The US government has a reputation for being reliable when it comes back to paying back loans and this is important for two reasons: 1. This means that the US is able to consistently issue relatively low-risk securities for investors, and 2. The US bond market is the largest of any country, worth approximately $51,000,000,000,000 🤯 ($51 trillion): 39% of the total bond market. Because the US bond market is so huge, it is just as important for the global economy as it is for bond market investors that US bonds remain reliable, which is why the US debt ceiling crisis could be a big problem if it isn’t sorted.
Why it Matters
The debt ceiling is the upper limit (hence ‘ceiling’) that the US government places on itself for how much borrowing it can do, thus limiting the amount of bonds it can issue to finance its spending, including interest payments on outstanding bonds. Currently the debt ceiling is at $31.4 trillion, and is usually raised every couple of years by congress to keep up with spending. However, a congressional deadlock ♜ between Republicans and Democrats is currently haulting this process. Republicans are refusing to sign off on a new debt ceiling without budget cuts, while Democrats want to raise the limit, no strings attached.
The trouble with this is if the ceiling can’t be raised, the US won’t have enough money to continue financing programmes such as social security or Medicare and make payments on its debts. This means that the US would start defaulting on its loans, which could start as early as June 1st. If the US, a reliable and massive bond market, suddenly wasn’t so reliable, there would be massive implications for the entire financial system.
According to some economists' projections of the impact, the economy could contract nearly as much as it did during the 2008 Global Financial Crisis in response to a default. It’s relatively unpredictable in terms of how exactly the economy would react to the US missing or pausing payments, but as the June 1st deadline approaches, the impact will likely begin to be felt through a downturn in the stock market. It is also likely that the US credit rating, its reliability score, would be downgraded and the US dollar would become weaker 📉.
Key Takeaways for You
Bonds are a low-risk fixed-income asset 💵
Bonds are usually considered less risky than stocks and can be a useful investment tool for people who are more risk averse and are a common component of retirement portfolios and pensions. They are loans for the amount equal to their face value that pay out coupons up until their maturity date, and have fluctuating prices.
2. The US bond market is huge 🌎
The amount of debt the US government issues in the form of bonds is tremendous and makes up a large portion of the bond market. Bonds are a key part of the global economy because they make up a big chunk of pensions, funds, and portfolios for both individuals and institutions. Uncertainty and default in the US bond market can therefore profoundly affect the entire economy and your own finances, whether you directly invest in bonds or not.
3. There may be some volatility on the horizon 📉
Hopefully congress will be able to come to an agreement that will allow the debt ceiling to be raised, or the US government will implement a crafty solution before the June 1st deadline. But, as that date and the threat of default approaches, it is important to be aware that this may cause some volatility or a downward turn in the stock market so you may want to consider how you are going to manage this risk.
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