BackThe problem with German bonds
The message of the recent bond market sell-off is that it is a risky environment for those who hold govt bonds
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Bond markets are considered safer than equity markets—and they are, most of the time. There are alternative bond structures and hybrid products, but in general, unless the issuer defaults, traditional bonds deliver a guaranteed income and repayment for your investment. More importantly, in a default, bondholders rank higher than equity holders when any remaining assets are being shared out. In stressed, uncertain times, you want to be in bonds.
Defaults are uncommon for the world’s safest borrowers such as the Federal Republic of Germany. Germany is the fifth largest economy in the world today, one of the most productive, has one of the lowest levels of public debt and rate of unemployment of any large industrialized economy and is currently running a budget surplus. Yet, over the past few weeks, Germany has been at the epicentre of a bond market rout. In just 17 trading days between 20 April and 13 May, almost $500 billion has been wiped off the value of global bond markets. Even Indian government bonds, which could not be further from Europe’s travails, fell in sympathy with bonds elsewhere over these 17 days.
It is not altogether obvious why German bonds sold off and others followed suit. Recently, there has been much good news for bond markets. The European Central Bank’s (ECB’s) bond buying programme has only just got going. Expectations of monetary tightening across the Atlantic have moderated. Inflation expectations everywhere are low. One popular explanation is that part of the rally in German bond prices over the past 12 months (and a consequential drop in German bond yields from 1.40% to just 0.077%) was based on the increased prospect of a Greek default and exit from the euro zone. Grexit (Greek exit) would raise the spectre of a euro-break up. That would in turn trigger a sharp appreciation in a putative new deutschemark and the liabilities of the German state denominated in the new currency. These are a lot of ifs, but markets continuously register the shifting probabilities of different states of the world. Even a modest 2.5% rise in the probability of a series of events that would lead to something like a 20% rise in the new deutschemark would cause German bond yields to fall by the 0.5% they did fall from January to April of this year. And would lead bond yields to rise by the same amount if the additional probability of Grexit then receded.
The supporting narrative is that combative Greek finance minister, Yanis Varoufakis, has been sidelined in the negotiations over Greece’s debt, making an agreement more likely and Grexit less. In a further triumph of optimism, the commitment of Greece’s radical Syriza government to take any agreement with its creditors to a popular vote is also seen as positive. The story goes that it gives a negotiated compromise political cover, and as this has always been a game of bluff, the Greek people are unlikely to exit from Euroland when asked to finally show their hand. Financial markets, where there is an omnipresent demand for explanations have a habit of latching on to accidental correlations and turning them into self-fulfilling prophecies. Whatever the initial reason for the sell-off in the global bond market, it is once more beholden to the ebb and flow of Greek debt negotiations.
However, the reality is that when 10-year bond yields are at 0.077%, it doesn’t take much to cause a sell-off. To justify yields at such low levels, an entire constellation of stars will have to remain aligned for an inordinately long time: there is no room for any inflation over the next 10 years, or any currency depreciation or any disaster that governments will have to step in to avert or anything else whatsoever. Yields are not at these levels because these fundamental risks do not exist. They are there because of a massive central bank bond buying programme that has already removed $5 trillion of US, Japanese and UK government bonds from private hands and has only just started in Europe, and because the regulation of financial institutions has made a fetish out of holding sovereign bonds.
The irony is that an extreme, artificial shortage, is turning safe assets into risky assets: bonds are so overvalued today, that they are prone to panicky sell-offs. This has been made worse by the reduced capacity of banks to smooth out concentrations of sell orders because of new capital adequacy requirements on their trading books and the extra volatility in bond prices that comes at very low yields. This all points to even greater volatility in financial markets than before and greater fragility of the balance sheets of financial firms. This is the real message of the recent bond market sell-off, one that goes far beyond the Greek tragedy. We are in a dangerous environment for those who hold government bonds and an opportune one for those who can spot the assets that have sold off too much, can buy them and hang on to them through the short-term ups and downs. It is unfortunate then that in international agreements, regulators believe it is safest to require insurance and pension fund institutions to switch more and more of their assets out of equities into government bonds. There are times that may be the case but to do so today would be to send ordinary insurance consumers and pensioners like lambs to slaughter.
Avinash Persaud is non-executive chairman of Elara Capital Plc, emeritus professor of Gresham College in the UK, and non-resident senior fellow of the Peterson Institute for International Economics in Washington.
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