A stodgy asset class has become more complex and more dangerous
Feb 11th 2012
FIFTEEN years ago Western government bonds were regarded as being like porridge: stodgy but easily digestible. Investors knew returns would be modest but perceived the asset class as risk-free, an important concept in both financial theory and portfolio construction. And bond markets were seen as all-powerful, capable of imposing discipline on governments by pushing up borrowing costs in the face of irresponsible policies. James Carville, an adviser to President Bill Clinton, spoke with awe of their intimidatory power.
Things are different now. The bond vigilantes seem less frightening. They were asleep at the wheel as debts mounted in the euro zone, waking up in time to provoke the latest crisis but not avoid it. Private-sector bond investors in Greek sovereign debt face losses of around 70%, making the idea that government bonds are risk-free laughable.
The most powerful investors in many government-bond markets are not profit-maximising fund managers but central and commercial banks, which are buying bonds for all sorts of reasons. Other investors need to be like Kremlinologists, guessing what central banks will do next.
The market is also much bigger than it was. According to Bank of America Merrill Lynch, there were some $11 trillion-worth of government bonds in issue at the end of 2001; by the end of 2011, that figure had risen to more than $31 trillion (see chart 1). And although some euro-zone countries have been cut off from the markets, the story is very different in other places. The British and American governments are enjoying the lowest borrowing costs they have seen for decades, despite big deficits.
The implications of all these changes are still being worked through. The risk-free rate has historically been the rock around which a financial system is built. Other borrowers, such as banks and corporations, pay a premium over their domestic government’s cost of debt. This is still true for companies that are tied to a local economy, such as utilities. But multinational firms can, in theory, move to economies where growth prospects are better and taxes lower. Some, such as Johnson & Johnson or Exxon Mobil, may thus now be seen as better bets than their governments.
Thanks to the European Central Bank’s lending activities, banks in several European countries can also now borrow more cheaply than their governments—a heavy irony given that it was the banking sector’s problems that ushered in the current sovereign-debt crisis. Indeed, investors have learned that simply studying the ratio of government debt to GDP is not enough. Both Ireland and Iceland entered the crisis with very low ratios. But the collapse of their banking sectors meant that private-sector debt was assumed by the government, causing the ratio to balloon.
Modern bond investors have to worry about other contingent liabilities, too—the pensions promised to public-sector workers, say, or the rising costs of Medicare as America’s baby-boomers retire. Governments might easily decide that such promises have a better claim on tax revenues than the rights of foreign creditors.
The negotiations in Greece have shown that official creditors deem themselves to have a greater claim on a government’s revenues than private-sector creditors. The more official aid a country receives, the bigger the eventual write-off private bondholders may suffer.
The rise of official creditors is not new. It was first noticed in the 2000s when Asian central banks began to plough their massive foreign-exchange reserves into Treasury bonds. Alan Greenspan, the then chairman of the Federal Reserve, talked of the “conundrum” that bond yields were falling even as the Fed was pushing up short rates, a shift from the usual pattern.
The reason was that central banks were pretty indifferent to low yields, being content to park their reserves in the relative safety and liquidity of Treasury bonds as a way to manage their currencies’ level versus the dollar. More recently, central banks have been buying up their own government’s debt through quantitative easing (QE). It is debatable whether yields are set by economic fundamentals or by the anticipated buying patterns of central banks.
Of course, central-bank policy has always had an effect on the bond markets. One way of viewing long-term bond yields is as a forecast of future short-term rates (sometimes there is an additional premium for tying up your money).
On that basis, says Eric Lonergan, a fund manager at M&G, the current level of Treasury-bond yields is quite rational. The average of American short rates over the past ten years is around 2%, almost exactly the level of the ten-year Treasury-bond yield now.
Rates are likely to remain low for some time. The Fed recently indicated that it expected rates to stay near zero until late 2014.
Add in the effect of QE and the Fed may be the dominant influence on yields all the way out to bonds with maturities of five years. There is talk of a third round of QE from the Fed, and the Bank of England was set to add to its £275 billion ($437 billion) pile of gilts at a February 9th meeting, held after The Economist went to press.
Rates low, bond mountains high
Analysts argue about the precise impact of QE on yields but the presence of an ever-willing buyer must have some effect. In particular, it must make private-sector investors cautious about betting on higher yields. “Bond crashes become very unlikely, unless they are accepted by central banks,” says Patrick Artus of Natixis, a French bank. “Long-term interest rates could remain very low for a long time.”
Less clear is how central banks will ever dispose of these bond mountains. In practice, it makes no difference whether central banks try to sell their holdings or simply let the bonds mature (since maturing bonds have to be refinanced). Either way the private sector will have to absorb the extra supply on top of the new bonds being issued that year. If central banks are correct in arguing that QE has driven bond yields down, then logically a reversal of QE might drive yields up, in effect tightening monetary policy. It may be a long while before the economy is sufficiently robust to absorb the impact. Large central-bank holdings of government bonds may be a semi-permanent feature of the landscape.
Central banks are not the only distorting presence in the market. In Britain pension funds have been eager buyers of long-dated securities as a way of matching their liabilities (a promise to make pension payments for 25-30 years is equivalent to a debt).
Since many pension benefits are linked to inflation, this has sparked a particular enthusiasm for inflation-linked debt. Insurance companies are also heavy buyers of government debt, in large part because of solvency requirements that push them into owning “safe” assets.
And then there are the banks. One feature of the early days of the euro was convergence. Short-term interest rates are the same across the zone. Since government-bond yields are related to expectations for future levels of short rates, bond yields equalised across the region. This was immensely beneficial for countries like Italy and Greece, which saw their borrowing costs fall. It also meant that banks happily owned regional, rather than merely national, government-bond portfolios.
Now that trend is reversing. Banks are suddenly conscious of the credit risk involved in holding another country’s bonds. When the crisis broke French banks were “encouraged” to hold on to their Greek bonds by their government and suffered losses as a result.
Now it seems they are willing to buy only their own government’s bonds, and those of Germany; they are far less keen on holding Italian or Spanish debt. “It is almost if the euro zone has already broken up,” says Andrew Balls of PIMCO, a fund-management group.
Domestic banks, however, may well figure that holding the debt of their own sovereign is a “double or quits” bet. If their government defaults the banking system will collapse anyway, so they might as well own its bonds. That incentive has been reinforced by the ECB’s provision of virtually unlimited three-year loans. As President Nicolas Sarkozy of France has hinted, banks can borrow cheaply from the ECB and invest the proceeds in government debt, earning a higher yield in the process.
This is an approach to boosting bank profitability that has been tried before. In the early 1990s the Federal Reserve held rates very low (by prevailing standards) to help the banks recover from the savings-and-loan crisis. Banks were able to earn a “carry” by borrowing at 3% and buying ten-year Treasuries yielding almost 7%.
The carry trade is not the only reason why banks might buy government bonds. In the wake of the 2007-08 crisis, when banks were suddenly cut off from the wholesale markets, regulators have been urging banks to own a “liquidity cushion” of safe assets. Banks can use government bonds as collateral for loans with each other, and with central banks.
The result has been a big expansion in banks’ sovereign-bond purchases, very handy when governments have lots of bonds to sell. In Britain, data from the Debt Management Office show that banks and building societies owned just £26 billion-worth of gilts in the last quarter of 2008; by the end of 2011 they owned £131 billion, or around 10% of the total (see chart 2).
How would you like your loss?
The role that credit risk is now playing in the euro area highlights another great change in the government-bond markets: the influence of exchange-rate regimes. For decades countries struggled to cope with the constraints of fixed exchange-rate systems, whether the gold standard or Bretton Woods, in part because this approach would reassure foreign creditors. “Who would be prepared to lend with the fear of being paid in depreciated currencies always before his eyes?” asked Georges Bonnet, a French finance minister of the 1920s.
But the euro crisis has shown the perils for international investors of a fixed-rate regime. Denied the option of devaluation, Greece is being forced, in effect, to default on its debts. In contrast America and Britain, with their floating exchange rates, have the freedom to expand their money supplies and depreciate their currencies. Although this may still result in losses for foreign investors, they are likely to be far smaller than the Greek write-offs. As Mr Balls puts it, countries with floating rates are the “least dirty shirt” in the markets.
Emerging markets have also changed their role. Historically, developing countries defaulted often and had high inflation. They had to borrow in dollars and to pay high yields. But now the finances of many developing countries are better than those of the rich world (see chart 3). Brazil and Mexico pay yields of less than 2% on five-year dollar-denominated debt.
It all adds up to a completely changed investment landscape. For the 25 years from 1982 to 2007, owning rich-world government bonds was almost a no-brainer. Yields fell steadily in line with inflation and there was no question of default. Now the market is much more complex. The players are more diverse and their motives more varied. The balance between risk and reward has also shifted against investors. In the past bondholders have not made money buying Treasury bonds on yields as low as 2%. At current levels of inflation, bond investors are getting negative real yields.
That may be the idea. Carmen Reinhart, Jacob Kirkegaard and Belen Sbrancia, three academics, have suggested that governments may use “financial repression”—forcing debts down the throats of captive buyers and keeping real rates negative so that inflation eliminates their debts. This trick worked after the second world war. The presence of “forced buyers” in the market such as central banks and commercial banks may enable it to be repeated.
But could governments really pull it off? Or are rich-world bond markets signalling that Japan is the more likely template? Ten-year yields there have been around 1% for much of the past decade, thanks to persistent deflation and slow growth.
This is a vital issue since a sudden surge in bond yields might wreck government finances, economic prospects and the outlook for other asset markets. “The unknown question is how much inflation central banks are willing to tolerate. Until that is settled, one cannot be sure about the outlook for bonds or other asset markets like equities,” says Manoj Pradhan at Morgan Stanley. For a supposedly risk-free asset it all adds up to a lot of risks.