|Jan de Ruiter, Country Executive of RBS Netherlands|
The success of this tactic is still a matter of debate, but one clear consequence of quantitative easing is that it has unnaturally pushed up the market price of government debt and, in turn, pushed down yields.
During the past two years, returns on five-year euro-area bonds have fallen to about 0.6 per cent from 2.75 per cent, hitting a record low of 0.24 per cent in 2012. Yields on debt with longer tenors have also plummeted, to 1.5 per cent from 3.5 per cent over this period for German bonds. In many cases, issuers are achieving negative real yield on their debt. This means the yield they are paying to investors is lower than the rate of inflation.
There is differentiation between yields on debt sold by countries in southern Europe, where the economies are more embattled, and those in the relatively more stable economies of northern Europe. For example, Spanish bond yields rose to 7.5 per cent in late 2010 and then dropped to 5 per cent, which is still well above the ten-year German bond yields.
This is a flight to quality in the euro region. Investors are afraid of the risk of the eurozone falling apart. This has created re-denomination risk in Europe, which we continue to see with lower rates in the northern zone compared to southern Europe. The north is benefiting from the issues in the south because investors can exchange sovereign risk for sovereign risk without leaving the currency. One could argue that the south is now in fact transferring value to the north.
The central bank actions have created a fantastic market for any issuer who needs to raise money from the capital markets. As long as they have a good credit profile, borrowers can raise long-term debt at extremely low prices from a diversified set of investors, as seen by Germany selling EUR184 billion of bunds last year alone. It makes sense for issuers to go for long maturities and lock in low interest rates.
However, the question has to be asked that if it is beneficial for issuers to lock in low interest rates for a long time by selling bonds, what are the benefits of fixed-income investors buying those bonds?
Quantitative easing means that the current low bond yields are not the result of normal market dynamics. They are artificial. Buyers need to be cognisant that they are investing in yields that have almost nothing to do with the strength of the underlying paper and almost everything to do with the extreme environment we are operating in.
The risk lies in the current extreme environment normalising. This is likely to occur when real interest rates rise and central banks stop buying debt and when the prices and yields of debt are once again determined by market movements and not by central bank bond-buying. Sustainable yields are, in my opinion, yields that cover for expected inflation plus a real return. When this will once again be the case is impossible to forecast because it is largely dependent on policymaking.
When normalisation does happen, which it most certainly will, the value of bonds will fall and yields will increase. This means the marked-to-market value of billions of euros of debt held in investors portfolios will drop, perhaps some sharply. The risk is that investors will have locked away funds in long tenors at then below market returns.
Its easier to say what will trigger normalisation than when it will occur. One such trigger is likely to be that the euro will stay together and overcome its current issues. In my view, it will also be the advent of greater fiscal integration of Europe and perhaps the introduction of eurobonds.
Normalisation will not happen gradually. It will be a sudden, step change marked by the willingness of investors to sell the north and buy in countries such as Italy, Spain and Ireland. This will cause yields to average and it will normalise the division that we have today.
So why are fixed-income investors buying European debt in almost record numbers? Quite simply, there is no alternative. Theoretically, if you expect rates to go up, then you would only invest in short-dated securities. However, yields on this debt are so low, it is not worthwhile. Yields on long-dated sovereign bonds offer the most attractive risk-reward for investors, even if the risk of investing in yields that are below the rate of inflation will pose problems in the future.
Pension funds are among investors that may be at the greatest risk because they buy long-dated securities to match their long-dated liabilities. If a pension fund holds an asset which goes down in value because of rate changes, and that movement is not properly hedged, the coverage ratio (or the value of the asset versus the liability) will go down. In addition, when hedging rate risk, investors have to bear in mind counterparty risk.
The difficult decision investors are being forced to make unfortunately has no easy solution. However, being aware that bond yields are, by nature of the extreme economic environment, artificial and as a consequence the risk-free rate may not be risk-free after all, should be discussed and debated in investment committees across the globe.
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