One indicator of how jittery investors are is that, for many, negative yields on sovereign debt seem attractive. In June, investors accepted yields of -0.08% to buy two-year bonds worth 1.55 billion Danish kroner ($265 million).
This means that if investors hold the bonds to maturity, they will be paying the Danish government to hold their money. This turns the traditional lender-borrower relationship on its head, but Denmark is only one example of a remarkable trend.
France, Germany, the Netherlands and Switzerland have all also sold debt with negative yields this year. On secondary markets, the two-year bond yields of Finland and Austria are also negative, while Belgium, one of the continent’s most indebted nations, is hovering near zero.
“Who would have thought there would ever be negative interest rates in two-year government bonds in countries such as Denmark?” says Yngve Slyngstad. Responsible for investments concerning Norway’s $660 billion Norwegian Oil Fund, Slyngstad can recall people saying that such a situation “would never, could never, occur.”
People said this would never, could never, occur Yngve Slyngstad Accepting negative rates may seem irrational, but there is a point to it. Investors are desperate to avoid potential losses on bonds from weaker countries such as Greece, Italy and Spain, so are flocking to the debt of countries considered “safe havens.” Return of capital, not return on capital, is the order of the day.
Continental Europe is not alone in bizarre bond behavior. Yields on UK government bonds (Gilts) and US Treasury Securities have dropped to historic lows as investors seek a hedge against rising consumer prices. In reality, this is not a recent turn of events. Once inflation is factored in, yields on short- and medium-term government debt have been negative for the past four years.
Yet, the paradox is that while yields are at record lows, many of these same governments are actually accumulating significantly more debt, which should worry markets and cause bond yields to rise. Rating agencies have already factored this in. Only last year S&P downgraded the United States, Austria and France from AAA to AA+, and yet yields in “safe havens” still remain low.
What is going on? One answer is that we are in the grip of financial repression. This ominous-sounding expression is a subtle form of debt restructuring. It includes “directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks,” according to
The Liquidation Of Government Debt (Carmen M. Reinhart and M. Belen Sbrancia, March 2011). REVIVING ANIMAL SPIRITS
Return of capital, rather than return on capital, seems to be the new name of the game. © Peter von Felbert
The current “no-yield” environment is a result of central banks trying to breathe some of Keynes’s “animal spirits” back into developed economies that have been performing more like roadkill since the Lehman bankruptcy. They’ve done this through monetary expansion, known as quantitative easing (QE – buying government bonds with newly printed money).
This comes at a time when interest rates have been cut to zero to discourage savings, and will likely remain so for the foreseeable future. Essentially, central banks are making a massive bet that low or negative yields and interest rates will be compensated for by economic growth. Such an approach makes it easier for consumers and companies to borrow, and thus stimulates the economy (and increases employment) – or so the theory goes.
Of course, this is good for another borrower of money: governments themselves. An environment with yields and interest rates below inflation rates enables them to refinance or pare back public debt. It is far smoother than a financial haircut and easier to implement than raising an unpalatable public discussion around expenditure cuts or tax increases.
Andreas Utermann, global chief investment officer at Allianz Global Investors, writes that the point of this “taxation by stealth” is that “bondholders and, more generally, savers are the ones picking up the tab. … It represents a redistribution of wealth from the prudent to the indebted.”
Financial repression is the modern equivalent of coin clipping, the shaving of precious metals from coins to fill budget deficits. In such an environment, savers lose money. Those approaching retirement are also in a precarious position. According to accepted wisdom, they should be moving from riskier stocks into bonds of various durations, yet with meager returns on offer in bonds, this path seems futile.
Low yields make the dream of a comfortable retirement more remote. They also double-down on losses of lifetime savings suffered from 2007 to 2008 when approximately 10% of private household financial assets were wiped out (
Allianz Global Wealth Report).
For pension funds, insurance companies and other institutional investors, the yield currently available is not sufficient to generate comfortable target returns for asset-liability management. Tom Otterbein, managing director at PIMCO, says that one consequence is that public pension plans in the United States are lowering return expectations.
“Across the board, everyone’s re-assessing return expectations. … But since there are costs associated with lowering expected rates of return for corporate benefit and public pension plans, there’s natural hesitancy,” Otterbein comments. “If they lower return expectations, then they have to increase contributions or cut expenses somewhere else in the budget. It’s not easy. … It’s painful.”
THE COST OF SAFETY
European pension funds – shell-shocked by increasing regulation such as Solvency II, changing accountancy standards and the roller-coaster market – had in recent years been driven more strongly towards supposedly risk-free investments. But safety has a cost.
Redemption yield of two-year government bonds
With pension liabilities having an average maturity of 20 years, such yields pose one of the biggest risks to funds. Indeed, it is ironic that, as one British investor commented, the “pensions regulator is pushing pension funds into sovereigns to de-risk just when sovereigns implode” (
, Allianz Global Investors, June 2011). Risk has many guises EQUITIES: VICTIM OR SAVIOR?
Given the decline in bond yields, institutional investors are being prodded to seek (positive) real returns elsewhere. For the moment at least, world equity markets are bustling, returning about 6% since midyear, juiced by the European outright monetary transactions (OMT) and the United States’ QE3 programs.
Neel Kashkari, head of global equities with PIMCO, dispels the notion that equities are dead, as was widely reported after an opinion piece by Bill Gross, the company’s founder. Rather, the “cult of equities” is dying, Kashkari explains.
“A 6.6% return after inflation, as proclaimed by the Siegel constant, is unlikely for the foreseeable future. To generate a realistic return of 3-4%, investment decisions have to be very selective,” says Kashkari.
Reinhold Hafner, CEO of risklab, a company of Allianz providing advanced assessment- management solutions, recently examined what could close the 3.5% gap between target returns of 5% and current actual bond yields of 1.5%. The study concluded that emerging- market bonds, absolute return strategies, hard currency and local currency bonds, and high- yield bonds all present opportunities.
Yet, the search for returns is being conducted in a volatile environment and so, caution our contributors, the hunt for real returns and security falls flat. In these circumstances, the notion of “security” needs to be redefined. It is no longer the absence of price movements, but rather with a return on capital, which explains the scramble for “safe havens” as an investment hedge. Perhaps the most worrying point concerning this big bet central banks have made on monetary expansion is that no one knows if it will work. Reinhart and Sbrancia identified 1945 to 1980 as an era of financial repression with interest rates in advanced nations in negative territory for around half the time.
Low bond yields and stock-market volatility have made it increasingly difficult for investors to prosper. © Peter von Felbert
This helped the United States, Europe and Japan whittle away debts from the Second World War. The difference is that economies were growing then, with rebuilding and capital investment matched by strong demographics. The same cannot be said today. Indeed, as both Jørgen Randers and Cambridge economist Partha Dasgupta discuss, it is no longer in our interests to pursue growth at any cost.
However, growth does not seem an immediate problem. As the OECD reported in September (
), the global economy has further weakened since spring: “economies both inside and outside the OECD area have been adversely affected by the euro-area crisis through trade and confidence channels.” What is the near-term global economic outlook?
With many economies barely registering a pulse, if not actually contracting, economists are not convinced that the benefits of financial repression can be repeated. In its
(“The limits of monetary policy,” Chapter 4, June 2012), the Bank for International Settlement (BIS) acknowledged that decisive action by central banks played a “crucial role in preventing a financial meltdown and in supporting faltering economies.” 82nd Annual Report
However, the BIS notes that the benefits of prolonged easy monetary conditions are more controversial. In particular, their implications for effective balance-sheet repair as a precondition for sustained growth, the risks for global financial and price stability, and the longer-term consequences for central banks’ credibility and operational autonomy are all subject to debate.
DEBT, THE UNIFIER
But the real concern four years after Lehman Brothers’ collapse is that there has been little meaningful reduction in the size of the exuberant liabilities created in the years of excess. Instead of being addressed, these liabilities have been passed on to public balance sheets and taxpayers.
As Reinhart and Rogoff remind us in
(Princeton University Press, 2009), a study of eight centuries of financial folly, “government debt is far more often the unifying problem across the wide range of financial crises.” Palming off debts onto the public means, it seems, we may just be setting ourselves up for further crises. This Time is Different