Default Risk and a Bond Trader’s Planning Horizon
I had a previous incarnation as a bond trader. I worked in the Treasury at the World Bank where I traded the Bank’s holdings in the UK Gilt market (British government bonds) back in the 1980’s. It taught me more about capital markets, monetary policy and exchange rates than graduate school did but it also brought me into close contact with traders and market participants of all types since I had one of the largest and most actively traded portfolios in the market.
My marching orders were “Don’t lose money and make some if you can”. It is fair to say that my colleagues in the Bank and I had very long horizons compared to other traders in the market for two reasons – First, our salaries didn’t depend on our trading decisions (How I wish that weren’t true – I would be a much richer economist today …) and second, we computed our performance on a very ad hoc basis, with grand evaluations vs. various benchmarks on a quarterly basis. Even then, a poor showing in one quarter just meant a reevaluation of strategy for the next in a portfolio where monthly and quarterly changes were not regarded as fundamental indicators.
What of the other traders and institutions? My impression of most of them is that they cared desperately how their book looked at the end of each and every day. The end of the week was important and the end of the month a cause for extreme anxiety. A bad quarter could well be career changing. A bad year and they were looking for a job. (By the way, WE thought bond traders were paragons of futuristic thinking compared to currency traders with whom we communicated regularly. Those guys bet immense sums and flip them back and forth within a trading day. They seemed to me to have the attention span of a flea.)
So the point of this post is to solicit opinions. Down there in the trenches the capital markets didn’t seem nearly as perfect and all seeing as they are often painted. Indeed, it was possible to make some large sums of money exploiting what looked like obvious profit opportunities to us. Could it just be that the people making the decisions aren’t thinking about what will happen in 20 years? And 20 years is well beyond the professional lifetime of most bond traders – How many 45 and 50 year olds do you see on a trading floor? Remember, even many of their bosses are just traders who graduated to management after a while.
Could the explanation for the lack of a default premium in US bonds be partly due to the fact that it is far in the future as compared to default premia on other countries’ bonds where the threatened disaster is more imminent? Or is it just that such a default really is unthinkable and so gets a low enough probability in traders’ minds as to be undetectable?