The Effect of Deflation on Debt
- Debt is often used as a general term to describe various forms of lending and borrowing, such as bonds, bank loans or mortgages. Loans are generated for a specified period of time, with interest payments usually fixed for the life of the loan. If the loan is packaged in small denominations and registered with the Securities and Exchange Commission (SEC), it can be traded in the secondary market and is called a security. Investors typically buy debt in the form of bonds. Bonds are issued by governments and corporations.
- Most bonds are issued with interest that is fixed for the life of the bond. For example, a 5 percent, 20-year bond means that its holder will collect $50 on each $1,000 of principal for the next 20 years.
- When prices are falling, $50 in interest income will buy you more over time, so the bond becomes a more valuable asset. Its price will likely go up as other investors will be willing to pay more for the income it generates. Interest is the price of borrowing money, so a period of deflation is also characterized by falling interest rates. When interest rates fall, bond prices rise.
- Falling prices mean lower revenues and incomes. When a borrower's income is falling but it still needs to pay the same amount of interest as before, that debt load becomes more burdensome because it takes up a larger proportion of the borrower's cash flow. In extreme cases, deflation may destroy a borrower financially if it is unable to refinance the debt at a lower rate.
- As interest rates fall, borrowing becomes cheaper. Borrowers who can pay off their high-interest debt and borrow at a lower rate do so. Corporations and governments issue lower interest bonds and use the proceeds to pay off high interest bonds, while consumers refinance mortgages at lower interest rates. Investors' interest income falls as a result and they start chasing yield -- looking for riskier assets that will pay them more interest. Smart borrowers with good credit use a period of low interest rates to borrow more.
- Long-term interest rates are usually higher than short-term interest rates. But when interest rates fall, long-term and short-term interest rates both decline proportionally in absolute terms. As a result, shorter-term bonds are replaced with longer-term bonds and new borrowers prefer to borrow longer-term to lock in attractively low rates.