Bond Vigilantes: Prices, yields and incentives

Question

I read on Wikipedia that a bond vigilante is "a bond market investor who protests monetary or fiscal policies they consider inflationary by selling bonds, thus increasing yields.".

I tried reading the Wikipedia article on bond valuation, but I still don't understand how this mechanism works.

1. Why is it that the selling of bonds leads to an increase of their yields?
2. Why is it that a rise in yields increase the net cost of borrowing?
3. What are the incentives for the bond vigilante to sell his/her bonds?

Answer 1

A large number of bond holders decide to sell their bonds. If they all decide to do this at the same time then there will be a large supply of bonds being sold in the market. This will drive down the price of the bonds which will increase yields.

Why do bond yields move inversely to bond prices?

You purchase a $100 bond today that yields 5%. You spent $100. The very next day the same bonds are being sold with a yield of 10%. If you wanted to sell your bond to someone you would have to sell it so it competed with the new bonds being sold. You could not sell it for $100 which is what you paid for it. You would have to sell it for less than the $100 you paid for it in order for it to have the equivalent yield of the new bonds being sold with a 10% yield. This is why bond yields move inversely to bond prices.

Why does rising yields increase the cost of borrowing?

If someone is trying to sell new bonds they will have to sell bonds that compete with the yields of the current bonds already in the market. If yields are rising on the existing bonds then the issuer of the new bonds will have to pay higher interest rates to offer equivalent yields on the new bonds. The issuer is now paying more in interest making it more expensive to borrow money.

What are the incentives for the bond vigilante to sell his/her bonds?

One reason a bond holder will sell his/her bonds is they believe inflation will outpace the yield on the bond they are holding. If a bond yields 3% and inflation is at 5% then the bond holder is essentially losing purchasing power if they continue to hold onto the bond. Another reason to sell would be if the bond holder has doubts in the ability of the issuer to repay the interest and/or principal of the bond.

Answer 2

Bond prices move inversely to their yields. So when you sell bonds and create a supply side deluge, bond prices will fall. Since bond prices are falling, yields go up. (The dollar amount that the bond pays out is the same. It's simply that since the bond price has fallen, that dollar amount paid out expressed in percentage terms of the bond price has risen).

Answer 3

Beyond the yield/price relationship, a good intuitive way to understand it is just this: these people control a substantial amount of money that could be essentially loaned to governments.

If they feel a particular policy is likely to lead to inflation or default, they may decide not to loan that country any more money. All else being equal, with a smaller supply of possible borrowers, the country will have to pay higher interest to fund a particular amount of debt.

Furthermore they may loudly publicly announce that they will no longer lend to that country, in which case other participants may be persuaded that they too should no longer lend at the going rate. What's more, this is somewhat self-fulfilling: as rates go up, the country will spend more money servicing its debt, and will in fact become a worse risk.

So I think the thing that gives them their "vigilante" nature is that governments worry they will round up a posse and things will run away.

As far as actual incentives, I would welcome more information but I think the main bond vigilante case is that they are basically long on the country but want it to tighten up its policy so their existing holdings don't decline.