August 22, 2014 6:30 pm

The bond paradox and how it will end

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Prices have soared despite huge issuance
Stack of Bond Certificates©Fuse/Getty

The world has never been in as much debt as it is now.

If that sounds worrying, consider this: with interest rates in the US, UK, the eurozone and Japan still at record lows, individual, business and government debt levels are still rising.

By the end of 2013 household debt in the UK had climbed above the high-water mark set in 2008 when the financial crisis hit, while the UK government now owes £1.6tn to its creditors around the world, equivalent to 91 per cent of all the goods and services the country produces, according to the International Monetary Fund.

Look across to Europe and this level of debt can look almost restrained. After a financial crisis that left it in need of a multibillion-euro bailout, Greek national debt is equal to 174 per cent of the country’s GDP.

Thanks to a vast stimulus programme, China’s debt load is now more than two-and-a-half times the size of its economy, up from one-and-a-half in 2008.

The idea of countries and households taking on trillions of dollars of credit sounds worrying, but conversations about debt require a sort of doublethink. On one hand, debt is a symbol of the world living beyond its means, borrowing from future generations to pay for the profligacy of the present. On the other, it is a marker of prosperity, growth and confidence in the future.

In a recent report on household spending, the Bank of England pointed out that higher debt levels can be a signal of improved welfare, suggesting households are raising their consumption to match expectations of higher income.

Not everyone was convinced. The Bank’s deputy governor, Sir Jon Cunliffe, believes high household debt threatens the UK’s economic recovery, pointing out that once mortgages are taken into account, consumer debts are equal to 135 per cent of household earnings, compared with 110 per cent in 2000.

Gov bonds 1

At a global level, a banking watchdog has warned that rising debt ratios leave the world vulnerable to another financial crisis. Countries are at risk of falling into a “debt trap” if ultra-low interest rates continue, says the Bank for International Settlements.

You might expect that as governments issue trillions of dollars worth of new bonds to bridge the gap between spending and tax revenue, the prices of those bonds would fall. That’s the usual result of a big increase in supply.

But for fixed-income investors, these are boom times. A bull market in government bonds that dates back three decades is still in full swing.


Teflon bonds

So far in 2014, price rises in European government debt have pushed down yields (which move inversely to prices) to record lows. Yields on Germany’s benchmark 10-year debt dropped below 1 per cent for the first time in August.

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In the US, the equivalent bond yield has dropped below 2.4 per cent – forcing analysts to reconsider their predictions for the rest of the year. US 10-year government bonds, called Treasuries, set the tone for global markets.

Bonds’ resilience is all the more remarkable because in the US (and the UK), investor attention is starting to turn to when base lending rates might rise.

Indications that the US was getting ready to pull back on its bond buying programme last year led to the so-called “taper tantrum” of falling bond prices in other parts of the world. This offered a convincing argument of what was to come, says Steven Major, global head of fixed income research at HSBC.

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The accepted theory for 2014 was that investors would turn their backs on bonds, opting instead for equities. In fact, bond markets have flourished, forcing investors to reconsider the level of risk they are willing to take in credit markets to find respectable yields.

Debt sold by European countries that once faced a forced exit from the eurozone has attracted levels of interest that would have seemed incredible two or three years ago.

Portugal, which needed a bailout in 2011 was able to issue €3bn of bonds this year in a sale that attracted investor orders amounting to nearly four times that. Greece, almost forced out of the eurozone two years ago, had investors putting in orders of €20bn when it sold debt in April. The demand pushed down yields, so investors ended up lending money at less than 5 per cent to a country that came close to default.

“The investors were not specialists in risky debt either, but ‘real money’ investors,” points out Philip Brown, head of sovereign capital markets at Citigroup.

The switch into riskier bonds isn’t confined to Europe, either. Flows of money into emerging markets have also swung up, with the “taper tantrum” swiftly forgotten.

Countries such as Ecuador, Ivory Coast and Pakistan have returned to markets – after years of civil war, political turbulence or debt defaults – to find investors more than willing to lend at rates of just 6 or 7 per cent. Those are the sorts of yields that prime borrowers such as the UK or US had to pay before the financial crisis.

Why are governments able to borrow so cheaply, given the high levels of debt around the world and the threat of higher interest rates?

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A big factor is the low interest rates and quantitative easing policies pursued by much of the western world in the aftermath of the credit crisis. The Federal Reserve and the Bank of England have created vast amounts of new money, most of which has been used to buy debt issued by their governments. Low bank interest rates have forced investors to look elsewhere for safe assets that generate income.

In Europe, the “jawboning” of European Central Bank president Mario Draghi has been pivotal. He has convinced investors that the ECB will stand behind debt issued by eurozone countries, making Greek and Portuguese bonds look safer.

Regulation has also played a part. Governments want banks and insurers to hold more capital in safe assets as a guard against future turbulence. That has led to “financial repression” – obliging companies to hold more bonds, whether or not they consider them good value.

Finally, while debt levels may be very high in many developed countries, worldwide there is a glut of savings. There have been plenty of willing buyers for all those bonds.


What next?

But the question left unanswered is what will happen to all these IOUs once the UK – and especially the US – feel that economic recovery is sufficiently robust that official interest rates can rise.

Gov bonds 3

Once that happens, low bond yields look less attractive, so prices tend to fall and yields rise. That means investors who buy bonds at low yields could be locking in uncompetitive returns or face a capital loss if they sell before maturity.

Rising interest rates at home also reduce the appeal of debt issued in emerging markets, where yields tend to be higher.

But despite recovering economies, central banks appear in no hurry to raise rates. In the UK, they are unlikely to start going up until 2015 because wage growth has been much weaker than expected. Mark Carney, the governor of the Bank of England, has repeatedly referred to a “new normal” level of interest rates, well below the levels of 1980s and 1990s. The Federal Reserve has also been careful to qualify any talk of rate rises.

And bond-friendly monetary policies are still being actively pursued elsewhere. The main eurozone lending rate was cut to 0.15 per cent in June, while the Bank of Japan is still aggressively buying Japanese government bonds.

“Debt has been rising around the world,” says Darren Ruane, head of fixed interest at Investec. “Everyone expects things to normalise eventually, but there are so many factors out there keeping prices high that it’s very hard to say when.”


How to buy

Purchasing gilts is a straightforward process, either directly from the government’s Debt Management Office when new securities are issued, or on the secondary market through a stockbroker.

Unlike shares, gilts do not incur stamp duty reserve tax and there is no capital gains tax to pay on any profit at maturity. Unlike corporate bonds, there is always ample liquidity in gilts and transactions can be executed online at low cost.

Gilts offer lower returns than shares (see above) but certainty over capital and interest payments. They reduce overall volatility in a portfolio. But even so, many advisers believe they are too expensive at current levels. Index-linked gilts, which offer inflation protection, are even pricier.

Rod Davidson, a bond fund manager at Alliance Trust Investments, said although gilts look expensive, compared to German Bunds – which saw yields recently drop below 1 per cent – they are “very cheap”.

Although buying gilts direct is easy, many investors prefer to use a fund. A manager will structure the portfolio correctly and replace holdings as they mature. And for bonds issued by other governments, such as Bunds or Treasuries, a fund is the obvious choice.

Ben Willis, head of research at Whitechurch Securities, tips the Jupiter Strategic Bond fund managed by Ariel Bezalel. “We’re negative on bond markets in terms of the risks associated with rising interest rates, but some investors want holdings for diversification and income,” he said. “The flexibility of his mandate allows him to invest across the bond spectrum. There are still opportunities.”

There are also passive alternatives. Mr Willis recommends the L&G All Stocks Index-Linked Gilts tracker, which serves as an inflation hedge but has also delivered a strong performance over the past year. Vanguard, iShares, HSBC and Deutsche Bank all offer exchange traded funds that invest in government bonds.


A bond lexicon

Investing in bonds is very different to investing in equities, and fixed-income comes with its own arcane vocabulary. Here are some basic definitions:

Coupons: the interest that a bond pays, so called because originally investors tore off a coupon from a certificate when a payment was made. Coupons are usually expressed as a percentage of the bond’s par value.

Par: the price at which a bond is issued, and usually redeemed.

Yield: the most crucial metric. A “running yield” is calculated by dividing the interest payments, or coupons, (which don’t change) by the price of the bond (which does). The greater risk investors take, the higher the yield should be. The yield on benchmark UK government bonds is about 2.5 per cent. Argentine bonds have a yield of close to 10 per cent. When bond traders talk about yields, they usually mean “yields to maturity” or “redemption yields”. This expresses the total annual return an investor would receive if a bond was held until maturity and repaid.

Yield curve: this is the distribution of returns across bonds of different maturities. A normal yield curve slopes upwards, meaning that investors get more for lending money over long periods than short ones. If investors start to worry that an economy is slowing down and interest rates are going to fall, they will try to lock in long term returns and avoid short term bonds, resulting in a flat or even “inverted” yield curve.

Duration: this is measured in years, but expresses a bond’s sensitivity to interest-rate movements. If a bond fund manager says he has shifted into “short duration” bonds, he means bonds that are less sensitive to changing rates.

Gilts: the name given to UK government bonds, because the certificates once had gilt edging. US government bonds are Treasuries, German ones are Bunds and Japanese are known as JGBs.

Junk: one of several names given to bonds that are rated below BB+ or equivalent by agencies such as Standard & Poor’s and Moody’s. The opposite is “investment grade,” which is rated from BBB- to AAA. Debt issued by Australia, Canada, Denmark, Finland, Germany, Norway, Sweden, the UK and Switzerland is still rated AAA by S&P, along with that of Luxembourg, Liechtenstein, Hong Kong and Singapore.

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