Thursday, May 07, 2009

Inflation, Bonds and "Theft By Other Means"

May 7, 2009 


Theft is not limited to outright robbery; promising bondholders a return and then reneging on the contract is also theft, as is selling long-term low-interest bonds based on a low-inflation world for decades to come.

Correspondent Craig M. recently wrote about the consequences of the U.S. Government strongarming Chrysler bondholders to accept a position in the back of the creditor line.

I believe we are in the very early stages of the collapse of the US corporate bond market. With the U.S. Government's abrogation of the legal rights of secured bondholders in favor of employee pension commitments and its likely replay for GM, it is becoming very clear (at least to me) that the rights of corporate bondholders are suddenly being eroded by government fiat.

In the near future I would not be surprised to see significant offshore selling of US corporate bonds. I would also not be surprised to see to failures in the offerings of new long-term corporate bonds as institutions and individuals demand much shorter durations and higher interest rates.

This vicious cycle will be exacerbated by the US Treasury's gigantic financing needs. In the end I believe we will see the failure of the US corporate bond market.

Thank you, Craig, for these thought-provoking comments. If the contract between companies and those who purchase their bonds can be renegotiated by strong-arm governmental action outside the bankruptcy courts, then what protection does a bondholder have? What assurances in the form of a higher risk premium will bond buyers demand in return for this unwelcome injection of uncertainty in the future value of a bond and its contractual status? Perhaps (as Craig notes), those seeking to invest in bonds will shun U.S. corporate bonds rather than risk having their bond "stolen by other means."

As I understand it, bondholders are generally first in line when a company goes bankrupt for the simple reason they were promised a position ahead of other creditors in return for the use of their cash.

Now on top of unprecedented governmental involvement in major financial and auto companies in the form of loans, preferred equity stakes and outright gifts, reports indicate that Chrysler bondholders who balked at accepting lesser rights (and thus a lot less money) than they were promised were openly threatened with government harrassment of the "you'll never work in this town again" sort.

Hmm. Isn't this essentially "theft by other means," the taking of one owner's stake and transferring it to another stakeholder? (In this case, the UAW and the government itself.) The strong-arming was necessary, it seems, to "make it legal," i.e. there is a gun at your head but you signed the deal of your own free will, heh, just like the good old NKVD and KGB method of extracting "confessions."

What Craig is referring to in his last comment is the competition between governments and private enterprise for private capital.

If the government squeezes out all low-cost private borrowing because it is borrowing $2 trillion a year to fund various bailouts and deficit spending, then isn't this a "taking" as well? If the government's stupendous borrowing operates in an open market with diminishing surplus capital available, then its borrowing will drive up interest rates as supply (the amount of surplus capital in the world available for lending) is smaller than demand (the voracious need for cash by governments running huge deficits).

Now the Federal Reserve has been playing games with the bond market by essentially printing money and using it to buy U.S. Treasury bonds, thus removing any real-world pricing pressure on the debt being issued.

Many commentators feel that this suppression of interest rates in the face of unprecedented global governmental borrowing cannot last; eventually the cost of money will rise.

Consider what it means to sell a long-term bond with a maturity 10, 20 or 30 years in the future at a very low rate of interest while at the same time you are increasing the money supply by trillions of dollars, essentially pulling out all the stops to create inflation, which will quickly rob the bondholders of most of the value of the shiny new bond you just sold them.

If that isn't "theft by other means," I don't know what is.

Have we really come to the point where we no longer care what our government steals by other means, as long as we get our $250 "special recovery free money" Social Security check this month and the banking sector is "healthy again"?

Will we care if our parents or our 401K retirement fund buy a 30-year T-bill on the implicit promise that 4% interest will be a fair rate of return 29 years hence? Will we care if and when inflation/interest rates exceed that low rate of return and the bond loses most of its value?

Maybe all we collectively care about is a rapid return to "the prosperity of 2006" by any means necessary. If so, we are about to experience a betrayal beyond easy measure. 

Thank you, Gerard F. ($20), for your most generous contribution to this site. I am greatly honored by your support and readership.

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