17th June 2016 by Chris Iggo
Knowingly or otherwise, bond investors have entered a deal with the devil. Capital will be preserved by policy, at the expense of the return the holders of capital receive on their bonds. As time goes on and the less confidence markets have in central banks being able to deliver reflation, the deal becomes even more expensive for bond holders. There is more yield give up to ensure capital preservation. This is the result of the low risk policy framework we have today. Wealth preservation is preferred to really going for inflation or really cleansing the system of bad debts. It works against risk taking – the paradox of lower and lower borrowing costs. So don’t be surprised that German 10-year bund yields turned negative. It’s the price investors pay for extreme risk aversion. At some point it may become clear that to get out of this malaise, we might have to accept the trade-off between wealth loss (through inflation or defaults) and renewed growth. Until then, bonds might just keep on outperforming equities, even with negative yields.
Paradox of thrift? – As the benchmark bond yield for Europe sailed into negative territory this week it highlighted to me again that the major structural problem the global economy faces is too much savings relative to investment opportunities. Hence low and falling real interest rates. There is not enough investment (borrowing) because there is already too much debt (in the aggregate). The resulting slow growth and low inflation economic climate suppresses expectations for future incomes. As such, in an ageing world and a world of low interest rates, it is hard to dissuade individuals from saving. If you have debt then you need to pay it back at the expense of consumption. If you are saving for retirement and have a target income or level of wealth in mind, and investment returns are low, then you need to save more. Keynes wrote about the “paradox of thrift” whereby people saved more during difficult economic times which meant that total savings rose and aggregate demand suffered, making growth even weaker. The policy recommendation was that government spending had to boost aggregate demand and make up for the private sector lack of spending. Today low interest rates and quantitative easing (QE) have not encouraged households to stop saving and spend instead, while high levels of government debt is a massive constraint on the kind of fiscal pump priming that Keynesian policy would suggest. Few are able to see a way out of the malaise, hence the grind lower in bond yields globally.
Dealing with debt – There are a few choices to deal with high levels of debt. First you save and repay it. At the government level this approach manifests itself as austerity which has political ramifications as we have seen in a number of countries in recent years. At the corporate level it means de-leveraging and reduced investment. At the household level it means higher savings rates and lower growth in consumer spending. Added together, this all means lower growth and the debt to income ratio doesn’t shift very much. The second approach is to inflate away the real value of the debt by raising the value of the denominator in the debt/income ratio through trying to create inflation. Most QE policies have a target of raising inflation from very depressed levels in the wake of the financial crisis to a desired medium term level of inflation of around 2%. The problem is that 2% is not enough to have a material impact on the debt ratio. Moreover central banks are struggling to reach even that modest level. Hence the call for even more unconventional reflationary policies like outright monetization of government deficits – addressing problems of both insufficient aggregate demand and low inflation. Direct funding of fiscal spending by central banks could create jobs and increase the velocity of money. I still think that this is a policy route that may be seriously considered at some point in the coming years. A third approach is to merely make servicing debt more affordable. Lower interest rates and bond yields reduce debt servicing costs and ensure that less income has to be directed to pay for debt. The problem with this is that the stock of debt is still a constraint on balance sheet expansion and that it prolongs ‘zombie indebtedness’. However, this is the approach that has been taken in today’s world with monetary policy delivering lower and lower borrowing costs. Debt to GDP can remain high if the debt service ratio remains low. We can all guess what the implications of an increase in interest rates would be in areas like the UK housing market, China’s state owned sector and for southern European governments. Finally there is default. However, the wealth destruction that would be associated with widespread debt restructuring or default is taboo. Do we really prefer maintaining wealth that returns less and less, or would we want to see a world where there is a cleansing of debt, a return to growth and an increase in investment returns that would – overtime – compensate for any burden sharing that resulted from debt restructuring?
The increasing cost of capital preservation – The contract between the owners of QE policies and bond market investors is that defaults will be controlled by the easing of the debt service burden but the cost of that is lower and lower returns on the debt. That contract drives the search for yield as investors move into increasingly lower rated parts of the bond market with the implicit promise that debt will be honored. Periods of stress in markets are met, time after time, with buying and I am sure that any weakening of credit markets in the wake of a ‘Leave’ outcome in the UK referendum will be short lived. Of course the demand for fixed income assets is also driven by regulation and the demographic requirement for capital preservation. In reality investors are not yet paying the German government for lending it money over 10-years, but if market yields remain in negative territory then new borrowing is likely to come with zero or extremely small coupons. In essence, investors are willing (being forced) to accept no return or negative return for the security of getting their money back. In the corporate debt world the yield ‘give-up’ for not losing wealth is becoming greater too. The 10-year plus part of the European corporate bond market has an average maturity of 13 years, an average credit rating of single A and a yield to maturity of just 1.7%. This was 2.5% a year ago and 4.8% five years ago.
The case for a policy shift – Lower interest rates mean governments spend less on debt service. Yet they are still constrained by existing debt levels and budget deficit limits. It is not as if the lowering of interest payments has led to widespread tax cuts or meaningful public investment spending. Keynes’s recommendation that the public sector makes up for the lack of private sector demand has not been followed because the focus has been on reducing public borrowing. If politics prevents us from writing off debt, why not at least extend QE so that effectively bonds are retired when the central bank purchases them. If all the government debt owned by central banks today was written off then debt to GDP ratios would decline considerably. The Bank of Japan is on course to own around 80% of all Japanese Government Bonds by 2020. Yes there would be a central bank accounting issue (mis-match between liabilities and assets) but that could be dealt with. There would then be flexibility for governments to spend, to create jobs, to boost disposable incomes, to raise productivity through investing in human capital and infrastructure. It’s not as if there is nothing to be done. It may lead to higher interest rates as growth and inflation pick up, but this would not be a bad thing, nor would it be a bad thing if higher interest rates led to corporate debt being written off. Better to accept some wealth loss in a world of positive economic growth than no returns in stagnating economies. Wealth destruction would not be equal across income cohorts given its concentration in the higher income brackets where the propensity to consume is already low.
If not, things carry on – This is all a bit off the track of today’s bond market but today’s bond market is just a barometer of the deeper structural economic problems. Monetary policy has been too timid in trying to reflate, choosing instead to keep the wheels on the cart. Increasingly the cost of this ‘wealth preservation’ is negative yields and zombification. Yields are getting lower, there is no sign of any meaningful upturn in global inflation, growth expectations are deteriorating and the implications of all that are seen in the increasingly toxic blame game that is modern day politics. For investors, the bond market can still provide capital preservation because that is what is being delivered by monetary policy. The cost is lower yields with still some spice if you want to accept marginally more chance of losing capital by investing in high yield and emerging markets. But even there defaults remain extremely low and debt servicing is comfortable on the whole. If nothing changes, 2017 could see the majority of the European bond market in negative yielding territory but the unintended consequences of cash hoarding, market illiquidity and increasing fragmentation of the financial system might be even more evident. If one accepts all of this and does not see any immediate upturn in the global economy, why not buy 30-year US Treasury bonds with a yield of 2.4%, or if the investment horizon is shorter, high yield bonds with a repressed default rate?