Fixed Income ohne Staats-Schulden

Where to invest in fixed income if you worry about sovereign debt?

In these countries, inflation-adjusted ‘real’ yields are now negative. Unorthodox policy actions by leading central banks, in the form of quantitative easing and other liquidity-provision measures, have raised questions about the potential for future inflation. What can a fixed income investor do? The risks sovereign debt investors face – default, negative riskfree yields, inflation – are consequences of the dramatic changes in fixed income markets since the collapse of Lehman Brothers in September 2008.

Sovereign default risk has increased because deficit spending was used to prevent a depression. Fiscal authorities transferred private debt onto public sector balance sheets to rescue the financial system, and stepped up spending to avoid a collapse in aggregate demand. The result has been a stunning increase in government debt as a percentage of GDP, raising sustainability concerns in some countries.

Greece has already had to restructure its debt, and there are worries that other ‘peripheral’ eurozone countries could also face difficulties.

Central banks played their part in supporting the economy, slashing policy rates, providing emergency liquidity facilities to financial institutions facing funding problems, and engaging in purchases of government debt. They have put aside their traditional focus on fighting inflation and turned their attention to growth and financial stability. A particular concern is the exposure that governments and the financial system have to each other. Ensuring the mutual viability of sovereign and financial sector balance sheets has become imperative. Central banks are now key actors in helping to ensure fiscal sustainability, a tricky position for monetary authorities who cherish independence.

Shrinking the debt

The ugly truth is that there is too much government debt and, to ensure sustainability, it has to be cut. This can be done in a number of ways:

(I) Growth policies centred around structural reforms that will raise tax revenues to service debt, and reduce debt as a percentage of GDP;

(II) Austerity policies to raise taxes and/or cut spending, though this could damage near-term growth;

(III) Reduction of central bank policy rates below the inflation rate, with significant liquidity injections, to encourage investors to buy bonds, drive the term structure of ‘real’ yields negative and help refinance existing government debt at cheaper rates;

(Iv) Direct central bank purchases of government debt (i.e. quantitative easing) to drive state bond yields lower;

(v) Regulatory coercion of institutional investors (insurance companies, pension funds and/or banks), to create a captive investor base for government debt at artificially elevated prices;

(vI) Inflation, which would gradually reduce the real value of nominal debt and shrink nominal debt as a proportion of nominal GDP;

(vII) And finally, debt restructuring or outright default.

Growth and austerity measures could improve a government’s ability to service a debt load, benefiting bondholders. But structural reforms can take years to bear fruit, while austerity measures bring near-term pain (particularly when interest rates cannot be cut further). The economic slowdown in Portugal, Ireland, Spain and Italy shows the impact of austerity on growth and that debt–to-GDP ratios will continue to rise for years before peaking.

For investors concerned about sovereign credit risk, directing investments to countries with the most favourable fiscal ‘health’ is an appropriate answer, though they should assess how much return to give up. In the eurozone, Germany and Finland are seen as the most secure credits and trade at a premium, even to France and the Netherlands. Following the European Central Bank’s (ECB) three-year Longer-Term Refinancing Operations in December and February, that premium is now considerably lower than it was in late 2011.

Financial repression

Lowering yields will generate capital gains for existing bond holders. But new investors buying bonds at low, or even negative, real yields find themselves short-changed of potential future returns. These ‘financial repression’ policies essentially tax the income of future bond investors. On the other hand, by reducing the differential between GDP growth and the interest rate a government pays on debt, financial repression can prevent eventual restructurings or defaults which are generally extremely painful for bondholders.

Very low yields are an obvious headache for bond investors looking to generate income and capital growth. In an environment where interest rates will remain low and stable, and additional economic and financial stresses are avoided, high-quality corporate and mortgage debt can be an attractive proposition to enhance yield. Clearly, yields are likely to rise one day, and investors may wish to limit the maturity or duration of any bonds they purchase to limit capital losses.

One problem with financial repression is that it removes the economic pressure on governments to forcefully address fiscal problems. In addition, central bank quantitative easing, which essentially amounts to central bank financing of government spending, raises fears of inflation. By monetizing government debt, and injecting liquidity into the financial system, central bank balance sheets have ballooned and the money supply has greatly expanded. Even the ECB, which is prevented by European law from financing government borrowing, has purchased government bonds by the billions, albeit under the justification this was aimed at promoting the functioning of the secondary debt market.

To date, that central bank liquidity has only generated asset price inflation, supporting financial wealth (and bond prices especially). But should the velocity of money increase (generating more economic activity in the ‘real’ economy), or should expectations of inflation rise, there is potential for this liquidity to generate goods and wage inflation. For bond-holders, higher inflation acts as a tax on the purchasing power of bond investments, devaluing nominal bonds.

Genie from the lamp

Is inflation a realistic threat? In the current economic climate, quantitative easing has failed to spur significant core inflation. G7 labour markets are too weak for employees to demand higher wages. However, it is worth noting that energy and food inflation has been strong in recent years, driven by demand from emerging markets whose economies have been helped by easy policy stances at the US Federal Reserve (the Fed), ECB and Bank of England, among others.

The long-term consequences of unorthodox monetary policy measures have yet to play out, and it may be that once released from the lamp, the inflation genie could be hard to put back in. Some central banks argue that deflation is a bigger threat than inflation. The Bank of England and the Fed have put financial stability and growth above price stability, at least in the near term. Fed Chairman Ben Bernanke recently acknowledged that he would tolerate a modest upside miss on inflation to achieve a better outcome on the Fed’s full employment objective.

For investors concerned about inflation risks, inflation-linked debt provides an obvious hedge against unanticipated inflation. At time of writing, 10-year inflation protection in the US Treasury Inflation-Protected Securities (TIPS) market is priced at 2.33%, slightly below the Fed’s 2.0% PCE index definition of price stability*. On German inflation-linked Bunds, 10-year inflation protection is priced at around 1.75%, also close to the ECB’s ‘2.0% or slightly below’ inflation objective. So inflation-linked bonds are reasonably priced for an investor looking for protection against some future inflation shock.

Cedric scholtesHead of Global Rates - Fischer, Francis, Trees & Watts (FFTW)

* 2.0% inflation on the Personal Consumption Expenditures index is approximately equivalent to 2.50% on the Consumer Price Index to which TIPS are linked.