Risks rise of a bondage boom and bust

How is all the existing debt to be serviced and repaid?

For how long – and how big – can the great bond boom continue? We are living through the greatest explosion of private and public debt in history. Governments and central banks around the world have resorted to ever more debt creation to sustain economic growth, activity and employment.

Here in the UK the most divisive general election in decades has brought ever more astonishing commitments to government spending and borrowing. The figures are dizzying. Promises are running into hundreds of billions. Previous debt constraints are abandoned as unnecessary or meaningless. After all, is not inflation down to a historic low of 1.5 per cent, and negative real interest rates rendering debt as good as costless?

But what a trap this has set for investors. For generations, government bonds were seen as a safe haven for pension and longterm investing, protected from the sudden and capricious swoops and swings of equity markets. Bonds delivered safer, more reliable returns. Many pension pots today have typically 60 per cent or more in bond and fixed interest assets.

Yet here is the paradox. The more that government debt markets have ballooned, the more restive investors have become, both over the totality of debt and the rockbottom yields on offer. Ten years after they were described as a temporary, emergency resort to the global financial crisis, they are still with us. In the UK ten-year bond yields are at 0.73 per cent, in the US 1.83 per cent, in Germany minus 0.33 per cent and in Japan minus 0.06 per cent. The longer these have persisted, bringing with it a flattening in the yield curve with little by way of extra reward for longer dated bonds, the more apprehensive investors have come to feel as to whether all this may end in a spectacular bust.

Throughout the 1970s the tide of financial opinion was that inflation was the ruinous risk and only curbs in government borrowing and spending would bring it down, with interest rates. Until this was undertaken, we were riding a tiger by the tail.

Today, by contrast, opinion in the financial world is altogether more ambiguous about debt and borrowing. So long as inflation remains low, governments can not only service their debt mountains but also issue more debt without undue risk. After all, as Oliver Blanchard, former chief IMF economist, recently argued, so long as interest rates remain below the rate of economic growth, governments can effectively borrow for free.

Yet doubts persist about how sustainable all this is. With bonds totalling $17 trillion now priced in with negative yields amid global fears of deflation, could UK gilts plunge to zero?

Meanwhile, how is all the existing debt to be serviced and repaid? Investors, after the equanimity and tolerance over the past ten years, may suddenly choke. Risk calculations move to the fore. Interest rates rise and, with these, the cost of borrowing.

And before we know it, we are staring into a bond market correction, with all the potential to spin into a rout and global slump. What for so long seemed an investment space of safety becomes one from which everyone immediately wants to flee.

However, if this is so serious a prospect, and the risks so potent, why have government debt markets not buckled yet? Up has popped what some pundits are calling modern monetary theory (MMT). According to investment commentator David Stevenson on the Citywire Funds Insider website last week, the various versions of this theory tend to agree that worrying about currency-issuing governments going bankrupt is wrong because governments (and their central banks) can always print the money they need. Governments could simply use monetary policy to expand demand – and then contract demand via tax rises if inflation does subsequently emerge.

Put that way, it hardly seems all that “modern” at all – more akin to the practices of desperate governments down the ages. Other versions include cancellation of debt issued under quantitative easing and Milton Friedman’s idea of “helicopter money”. The extreme version is, of course, Latin Americanstyle default.

For the moment, official policy seems to be “keep calm and carry on”: leave radical policy action until such times as it is necessary. But is this a stance with which investors are likely to remain comfortable?

Many, desperate to earn a return on their savings, have opted to remain relatively more fully invested in equities to secure investment income, but now have to contend with warnings about earnings reversals and dividend cuts. Traditional resort to a bond/ equity split of 50-50 or 60-40 for long-term saving now looks outmoded.

Investors seeking to avoid entrapment in a potential bond bust may have to cast their net wider to assign a portion of their nest-eggs to alternative areas such as infrastructure, commercial property, private equity and emerging markets. In the words of JP Morgan Asset Management’s John Bilton, “having that diversification, I think, is key in a low return world”.