20 February 2012
“The difference between
ordinary and extraordinary
is that little bit extra.”
Jimmy Johnson
4 October 2011
Bonds
Have Become A More Complex And
Dangerous Asset Class
Fifteen years ago Western government bonds were regarded as less complex as they are now.
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 Eurozone, waking up in time to provoke the latest crisis but not avoid it.
Private sector bond investors in Greek sovereign debt will likely face losses of around 70%, making
the idea that government bonds are risk-free less reliable.
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. 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. And although some Eurozone 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 be now be seen by some investors 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
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Duggan Asset Management Limited trading as Duggan Asset Management is regulated by the Central Bank of Ireland.
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 US Federal Reserve (Fed) was pushing up short term interest 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 US 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, it could be argued that 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 another £50 billion to its £275 billion pile of
gilts.
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.
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
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Duggan Asset Management Limited trading as Duggan Asset Management is regulated by the Central Bank of Ireland.
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.
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.
Prepared by: Mark Holland, Investment Analyst – Duggan Asset Management.
Tel: +353 (0)1 8044982
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Duggan Asset Management Limited trading as Duggan Asset Management is regulated by the Central Bank of Ireland.