What Does It Mean to Be a Bond Vigilante?

 

A bond trader who threatens to sell a significant amount of bonds or actually sells a substantial amount of bonds in order to protest or show disgust with the policies of the issuer is known as a bond vigilante. When an issuer sells bonds, the market price of those bonds falls, which causes interest rates to rise and makes it more expensive for that issuer to borrow money.

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Ed Yardeni, an investor, came up with the term in the 1980s during a time when bond traders were selling Treasurys as a reaction to the rising influence that the Federal Reserve and its policies had on the economy of the United States.

KEY TAKEAWAYS

• A fixed-income trader who sells bonds, or threatens to do so, to push back against particular practises implemented by the issuer is known as a bond vigilante.
• The phrase "bond vigilantes" was first used in reference to bond traders in the 1980s who were criticising the Federal Reserve's dovish monetary policies at the time. The word "bond vigilantes" was first used.
• Bond vigilantism indicates that market actors, and notably bondholders, have a significant amount of power that they may exert (or threaten to impose) over borrowers. This is especially true when bondholders take action.
• As a result of measures made by the central bank in the aftermath of the Great Recession, this practise became less common, but it could have resumed in reaction to growing inflation since the middle of 2022.

Understanding Bond Vigilantes

The interest rate at which issuers of bonds can borrow money from investors is reflected by the yields on those bonds. Bond prices tend to go down whenever yields go up; conversely, interest rates tend to push bond prices up whenever yields go down. However, the same association is true even if the price of the bonds decreases first; in that case, yields are compelled to increase in response.

Because of this underlying relationship, an active seller among bondholders can drive up the cost of borrowing for future issues, which can have a negative impact on the economy. This is due to the fact that when an issuer sells their bonds at ever-lower prices, the effective result is an increase in the interest rates they are required to pay out for succeeding bonds. Even though a bondholder who holds previously purchased bonds until maturity is unaffected by this action, the issuer stands to be put through a significant amount of unnecessary stress as a result of it. Typically, the goal of such a seller is to get revenge on the issuer for carrying out specific actions or policies.

For instance, the Federal Reserve chose to take a dovish stance during a period of growing inflation in the early 1980s, and as a result, interest rates were largely unaffected. However, bond vigilantes quickly developed to resist this policy since they argued that interest rates needed to be far higher in order to effectively counteract the effects of inflationary pressures. In the end, this strategy of selling off large amounts of government bonds did result in an increase in market interest rates; consequently, the Federal Reserve quickly followed suit and adopted a more hawkish position.

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Bond vigilantism indicates that market actors, and notably bondholders, have enormous power that they can exert (or threaten to impose) over borrowers. This is especially true when bondholders are concerned about the value of their investments.

Various Violent Crimes Against Bond Episodes

As was noted, financial guru Ed Yardeni was the one who came up with the phrase "bond vigilante" to describe the activities of huge bond traders in the Treasurys market. He noted that in the course of the inflation that occurred during the 1980s, "even before the Fed really started to aggressively raise interest rates, the bond vigilantes figured it out and kind of jumped ahead of the line and pushed interest rates up dramatically."

Yields on 10-year Treasurys rose from roughly 5% to 8% over the course of a year during the early years of the Clinton administration, which caused bond dealers to become dissatisfied with the huge government spending that was initially taking place during that era. Yields began their downward trend after the policy aimed at reducing the deficit was altered.

What’s the opposite of a bond vigilante? pic.twitter.com/nj1wAjRZkk

— JW Mason (@JWMason1) May 23, 2019

As a direct result of the financial crisis that occurred in 2008, a number of European economies, most notably those of the so-called PIIGS nations (Portugal, Ireland, Italy, Greece, and Spain), found themselves in the midst of a debt crisis. Yields on sovereign debt in these countries skyrocketed as investors came to terms with the enormous sums of liabilities that were coming due. According to Yardeni's observations, "When those Greek bond yields went up to 40%, they were clearly screaming that something was just dead wrong with the way that country was being managed, and things changed, and those bond yields came down." Still, there are many who believe that bond vigilantes are to blame for making it harder for these countries to recover. This is because bond vigilantes drove yields up so high that it became expensive to borrow money, which, in turn, made it impossible for these governments to operate effectively.

Bond Watchdogs Compete Against Activist Investors

Bond vigilantes are evidence that markets and major market actors can exert a significant amount of control over the actions of the issuers of the securities in which they trade.

One other illustration of this idea is provided by the phenomenon of activist investors. These are significant shareholders who have amassed a significant enough ownership interest to have influence over the management and strategy of the corporation. These activists are able to amass a sufficient number of voting rights as shareholders to win seats on the board of directors and supplant other corporate management, such as the CEO. They may also threaten to sell their shares on the market, which would bring the price of the stock down and reduce the value of the company on the market. (known as "the power of exit").

Is There Anyone or Anything That Serves as an Illustration of a Bond Vigilante?

PIMCO, which is a bond fund that manages roughly $2 trillion in assets, is a good illustration of a bond vigilante. PIMCO is famous for selling all of its holdings in United States government bonds when former manager Bill Gross was at the helm. Gross was of the opinion that the federal government's spending deficit could not be reduced.

What Became of the Bond Vigilantes is an intriguing question.

Bond vigilantes have been at a loss for what to do since the middle of the 2000s as a result of the attempts of central banks to keep interest rates at very low levels, particularly after the Great Recession. It became far more difficult for the simple act of selling bonds to have a major impact on bond rates as a result of the implementation of policies such as quantitative easing (QE). However, by the middle of the year 2022, it is possible that the vigilantes have reappeared as a portent of the delayed response of central banks to growing inflation around the world.

How exactly does the sale of bonds cause an increase in the cost of borrowing?

Bond prices and interest rates have an inverse relationship, meaning that when yields (interest rates) increase, bond prices will decrease. However, yields go down whenever bond prices go up. When an issuer sells bonds, the market price of those bonds falls, which causes interest rates to rise and makes it more expensive for that issuer to borrow money.

The Crux of the Matter

Bond vigilantes are major bondholders who use the authority afforded to them by their position to exert influence over the actions of bond issuers, be they corporations or governments. By manipulating bond markets, powerful market participants have the ability to significantly increase the cost of borrowing money for issuers as a form of discipline or punishment for what is considered to be mismanagement or policy blunders. The phrase "bond vigilante," which was initially coined by Ed Yardeni in the 1980s, has since come to be synonymous with activity in the bond market.