Rarely has the relationship of investors with sovereign debt been more ambivalent. The Western media tell us that we face a debt crisis, with debt-to- GDP ratios approaching 100%. At the same time bond yields on the large majority of outstanding sovereign debt (US, Core Europe) are close to historic lows. Real yields are even close to zero. How is this possible? And are the low yields sustainable?
Currently, about 25% of the 300 major non-financial companies in the US and Europe require a lower price to insure against default than the country they are listed in. Although one should not read too much in the pricing of the default-insurance (CDS) market, it does give a signal about the level of sovereign stress on the one side and the strong financial fundamentals in the corporate sector on the other.
Many non-financial companies benefit from exports to emerging markets, modest wage growth and historically low corporate tax rates. They have profited from the economic bail out which governments had to finance. However, despite their financial strength, even the biggest multinationals have to pay a yield premium relative to their governments.
The Western core countries will need to maintain this superior borrowing capacity. They will have to implement spending cuts and/or (corporate) tax increases. We may very well have to get used to structurally higher debt-to-GDP ratios, but they cannot keep rising exponentially. The US and Europe will have to balance their budgets . . . and financial markets will serve as a watchdog.
The crux of the matter is that there is simply no liquid alternative for sovereign debt. And we live in a world where the demand for this debt should even rise further. After all, the growing inability of governments to provide for their citizens will increase the need for these citizens to invest for the future themselves . . . largely in sovereign debt.
This may be even more true in fast aging European countries than in the US. Our unfunded state pension schemes will be eroded as the ratio between tax-paying workers and pensioners inevitably worsens. Retirement ages will move up and pension pay-outs are likely to deteriorate. People will have to take action themselves to enhance their state pension.
But aging is not the only factor which increases private demand for low risk investments. The lack of high yielding investment alternatives also plays a role. In the Western world, the vast majority of net wealth is held by the 55+ age group. These people have largely paid off their mortgages and have fully benefited from the strong rise in house prices, equities and bonds in the eighties and nineties, when the unique decline in interest rates from 12 to 4% caused an asset boom. However, this was a rare historic phenomenon, unlikely to be repeated in the next decades.
In the current environment, investment returns and house price developments will probably remain modest, making it more difficult to create a wealth buffer for the future. Perversely, the main source of wealth generation for youngsters may be their inheritance. Those who cannot look forward to a significant windfall - the vast majority – will face a growing need to invest for the future, largely through vehicles which invest in government bonds.
We think that growth and inflation in the Western world are likely to remain very modest and that demand for sovereign debt is likely to keep growing. We expect the major governments to move towards a more balanced budget. In that case there is still more reason to love sovereign debt than to hate it.
