Saturday, December 27, 2008

Discounted Repurchases: Coming Soon to a Bond Market Near You

Sovereign debt defaults do happen, especially in economies south of the border that elect not to pursue quantitative easing:

Ecuadorean President Rafael Correa wants debt negotiations triggered by the South American country’s second bond default in a decade to proceed in January.
(snip)

“We will make a proposal to rebuy these bonds, many of which have already given great yields to these speculators,” Correa said. “It’s likely that those who hold the bonds now didn’t buy them at 100 -- rather at 20, 30, or 40 -- so it’s not like these people are being hurt.”

IMHO it's safe to say that the U.S. Treasury is watching this process with interest. When the bond bubble in U.S. Treasuries finally bursts, Uncle Sam will be faced with the very attractive opportunity to retire a good portion of his debt by buying back bonds that have fallen in value. The Fed has already demonstrated its willingness to finance Treasury bond purchases by TALF-ing new money into existence.

The beauty of repurchasing debt at a discount is that it sidesteps any need to raise interest rates to attract new buyers to government debt. Bondholders will be crying for someone to take bonds off of their hands even at a loss.

Debt retirement at rock-bottom prices. Voila! Problem solved? Not quite. One of my finance professors in graduate school used to say, "There are no solutions, only changed problems." The next problem will be figuring out how to grow the economy after fixed-income investors have seen the lion's share of their bond holdings wiped out.