Bottom-feeding government bond yields

The reasons for low and negative real interest rates on government bonds lie in demographics, specifically, the declining birth rate in much of the developed world, and the simple fact that in a world awash in money created by central banks and saved by those planning retirement, there is no great need to pay much to rent it. Central banks, on this theory, are simply following these trends.

The basic economic model for setting rates is the supply of loanable funds and the demand for them. Over the past few decades, the world’s proportion of folks in their 40s and 50s – the boomers, more or less – swelled. Those are their peak earning years and, duly, they saved. Much went into stocks and bonds, driving returns of the former up and yields of the latter down.

Then, there is China and its “one child” policy. The traditional model of children taking care of parents has been eroded by the lack of kids, so families saved more and puffed up bank accounts. As a result, China’s banking system and government became the largest foreign creditors of the U.S. and other countries. Nations and companies wanting to sell bonds have not had to offer high rates to attract and store the Chinese hoard and, of course, they did not and do not.

The final nail in the coffin of interest rates in the formerly familiar range of 5% for 10-year government bonds in most developed markets is savers’ perception of risk. If savers consider the odds of a repeat of a massive market implosion on the scale of 2008-09 – which was, at its core, a bond market event caused by the collapse of misperceived risk on U.S. mortgage derivatives – as trivial, those investors will want little in a risk premium for their bank deposits and government bonds. Just pacing inflation should be enough. That is a low, single-digit situation.

Quantitative easing, which means flooding markets with cash paid for banks’ bond holdings, remains the fashion of the times. If money is almost a free good, then there is no need for financial services institutions to pay incentives to get people to save.

“Negative rates are a disincentive to save; a way of taking money out of the banking system. And, for private persons, a reason just to hold money in cash,” says Edward Jong, vice president and head of fixed-income at TriDelta Investment Counsel Inc. in Toronto: “In the U.S. and Canada, people keep their money in banks or maybe money market funds. But in Europe, where quantitative easing is still in force, people do hold value in art and other personal goods.”

The final nail in the coffin of the happy days of 5% for 10-year government bonds is the behaviour of institutions worried about mismatches of risk between what they must pay pensioners and life insurance beneficiaries over time and what those institutions earn on their bonds. As life expectancy rose, insurance companies and pension funds saw their potential bills rise. This encourages those institutions to buy ever-longer bonds.

As long as these institutions can just park their bonds with terms matched to their liabilities, they are happy.

The lower payouts of the bonds is a problem for pension trustees who may see that their bonds’ income will fail to meet the cash required by ever-older pensioners. But that is the trustees’ problem, after all.

What to do? Corporations and governments get cheap money when they borrow with low nominal interest rates. These borrowers also get loans subsidized by lenders when nominal rates are negative.

Sensible investors outside of institutions will shift more money to stocks that offer attractive and sustainable dividends.

There is market risk, of course, but the difference between 4% to 5% for a nice bank, utility or telco dividend and nada or less from a sovereign bond is huge.

And if, as shown, the perceived risk of another Great Recession is slight – it rates as one in 240,000 years in one survey – why worry? The reality is that stock crashes happen a lot more often (e.g., 1987, 1991, 1998, 2000-01 and, of course, 2008). But stocks recover and go through cycles that become shorter.

In the end, the traditional question of allocation of assets between bonds and stocks is about risk management.

“If you want to get what feels like a historical bond return, you have to go below investment-grade debt and take some default risk,” says Charles Marleau, president of Palos Management Inc. in Montreal. “At that level, stock risk and bond risk are more correlated.”

The bonds of any company carry less risk than its stock, of course. And if the company has a lot of debt and can pay less interest, the stock is likely to beat bond returns.

Thus, bottom-feeding interest rates make winners and losers.

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