An article titled “The Bond Buyer’s Dilemma” appeared in the Wall Street Journal

Question

An article titled “The Bond Buyer’s Dilemma” appeared in the Wall Street Journal on December 07, 2011. The author argues that “since the turn of the century, many of the developed economies of the world are burdened with excessive debt. Governments around the world are having great difficulty reining in spending. The seemingly less painful policy response to these problems is very likely to keep interest rates on government debt artificially low as the real burdens of government debt are reduced”. The author further argues “This represents a sort of taxation on bondholders for some time to come”. How do you justify the author’s argument about the “taxation” on bondholders?

Explanation / Answer

Debt restructuring can help a government in reducing its debt burden, as lower interest rates on bonds will result in reduced interest obligation for the government. However, with a decline in the fixed interest rate, bond holders are likely to receive a lesser rate of return on their investments. In reality, their real rate of return might become zero , or, in other words negligible.

Further, if the inflation rate continues to rise, the real rate of return may even become negative resulting in losses to bondholders. Since, the flow of income (to the bond holders) will get reduced during this period, it can be considered as a taxation on actual income that could have been earned by the bondholders. Therefore, the author's argument is correct in relation to the returns expected from the bonds.

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