Federal bonds and interest rate turnaround: How expensive debt has already become

With rising interest rates, not only private loans are becoming more expensive. The federal government’s interest costs also increase when it borrows money from investors. What does this mean for German public finances?

Yesterday, the federal government topped up a ten-year bond that it issued in July. He wants to earn an additional four billion euros. The state is financing its sharply increased expenditure due to the corona pandemic and the energy crisis through federal bonds and other securities.

For years, the federal government even made money by taking on debt. The reason was the negative interest rates – investors willingly paid for the security of investing in German government bonds. But that has changed. Loan repayments are becoming significantly more expensive. Due to the historic turnaround in interest rates in Europe, Germany is now having to pay for new debt again. What are the consequences for public finances?

10-year Bund yield at 11-year high

By issuing bonds, also known as bonds, states borrow money from investors for several years and pay interest on it. At the end of the term, you pay back the full amount. The focus on the financial market is particularly on the ten-year federal bond, which is traded most frequently on the stock exchange. Your rate of return is published daily by the Deutsche Bundesbank. The capital market interest rate for these trend-setting federal bonds yesterday reached its highest level in eleven years.

By midday, they were up 2.42 percent, the highest since 2011. At the beginning of the year, the yield on the ten-year federal bond was still minus 0.18 percent, in August it was just 0.8 percent. In September, for the first time in nine years, it broke the round mark of two percent.

What is the reason for the sharp increase in returns? “The answer is inflation,” says expert Friedrich Heinemann from the Leibniz Center for European Economic Research ZEW. The promise of repayment and the increased fixed interest rate in no way compensate for the price increases, so that investors sell their paper. The lower demand increases the yield. Yields and prices develop in opposite directions on the bond market. If the prices fall with an interest rate fixed for the entire term, the returns for investors who are new to them increase – and vice versa.

“Purchasing power is disappearing like snow in the sun”

“The real value of 100 euros in government bonds that I have in my portfolio has fallen from ten percent to 90 euros with the current inflation,” says the economist. Even if the interest rate and thus the yield on Bunds rose nominally, the real interest rate would actually fall. In real terms, i.e. taking inflation into account, government bonds currently have “negative returns as bad as never before”. “Today, the purchasing power of the money in bonds is dwindling like snow in the sun – despite the apparent interest rate hikes,” says Heinemann.

Investors are also expecting: on the one hand, further rising inflation and, on the other hand, new interest rate hikes by the central banks in the fight against the inflation wave. The key interest rates are relevant for the banks that take out loans from the currency watchdogs. This in turn has an effect on the capital market interest rates that, among other things, the states have to offer investors for the money on the bond market. If the key interest rates go up, higher interest rates for federal bonds are therefore expected. Because investors are also hoping for price stability in the medium to long term, the shares would also be attractive in real terms again after a few years.

The result: Investors throw the bonds out of their portfolios. And interest in new paper is also falling. After the federal finance agency responsible placed the ten-year federal bond in an auction procedure yesterday, the issue remained technically undersigned. The demand was therefore below the supply volume: instead of four billion euros, the state took in just under 3.9 billion euros.

Impact on the state budget

The high inflation and the changed interest rate environment also have consequences for the federal government. Overall, the income from the overall budget in the first half of this year increased by around twelve percent to 841.4 billion euros compared to the first half of 2021. Because expenditure has also fallen slightly, the deficit has fallen significantly to 32.9 billion euros. The drastic increase in prices plays a major role here, as a result of which the state’s income from value added tax increases sharply.

In return, however, the interest burden increases. Despite increasing debt, interest costs last year were only 3.9 billion euros. For comparison: in 2008 it was still 40 billion euros. Federal Finance Minister Christian Lindner (FDP) expects around 16 billion euros again this year – and the trend is rising. As early as 2023, 30 billion euros are planned for loan financing.

This includes the annual interest payments on current government bonds or other government securities. However, because these interest rates are fixed, spending will remain stable for the time being. The situation is different with so-called inflation-indexed securities, where the interest rate is based on inflation. In contrast to the federal bonds, the payments are only due at the end, but the state has to put money aside every year. After 735.7 million euros in the previous year, according to the federal financial plan, 4.6 billion euros are planned for the current year and 7.6 billion euros for the coming year.

Interest rates rise more slowly than prices

The biggest change, however, is the issuance of new bonds. “In addition to long-term financing, old bonds have to be replaced by new ones or increased year after year because of the current deficit,” says Heinemann. For 2022, the Federal Finance Agency expects a total issue volume of 410 billion euros. “If 2.5 instead of zero percent interest suddenly had to be paid when new bonds were sold, that would have been ten billion euros more in interest payments this year alone,” said the expert.

In addition, there is the so-called “disagio effect”: When issuing new bonds, the federal government currently has to pay a surcharge on the purchase price – which is added to the annual interest payments. In particular, when tapping bonds with a fixed interest rate of zero percent, the Treasury Secretary pays more because investors would not buy these securities at face value given the poor yield compared to other bonds. Expenditure of 8.6 billion euros is estimated for this. Until recently, things were different: because of the negative yields on the bonds, the federal government received even more money from investors than it had to repay at the end of the term (“agio effect”). This additional income – in 2021 alone it was 13 billion euros – is now gone.

“Now the state has to pay positive interest rates again,” says Heinemann. However, at the same time, the gross domestic product (GDP) is rising due to high inflation, which means that the debt ratio, i.e. the ratio of government debt to GDP, is falling. “At the end of the day, the state benefits in times when interest rates rise much more slowly than prices.” In this way, the real value of the national debt is “gradually disappearing into thin air”. The acute phase is therefore not particularly stressful. This is only due when inflation falls again at some point.