Can borrowers continue to hit the jackpot?
“As a civil servant on a small salary, I hate inflation because it erodes my disposable income. But as a debt manager, I love it. So said the head of a European debt management office at the OMFIF summit on public sector debt on May 17. The event brought together over 20 investors with a similar number of sovereign, supranational and agency issuers to discuss key issues in the debt markets.
It was quite easy to grasp his point of view. He said statistical models suggest 10-year financing costs are extremely low compared to historical levels, even for the relatively highly indebted country he represents. Adjusted for inflation, these costs are now deeply negative.
Another SSA borrower at the top, who put current funding rates in historical context, echoed that. “Those of us who were active in this market before the Eurozone was created saw funding costs go from double digits to under 10%, then under 5%, then under 3%, then to zero,” he said. . “For sovereign borrowers, it’s like hitting the jackpot.”
It’s a jackpot that has continued to pay out far longer than most commentators predicted several years ago. A European pension fund manager on the panel, titled “Issuers, balance sheets and reserve managers – the post-QE challenge”, said unwary bond investors were caught off guard by what he described as of “false signals and promises” for nearly a decade. “As early as 2014, many headlines were predicting the imminent normalization of the yield curve,” he said. ‘It still hasn’t happened. So I don’t think investors can be blamed for not believing things will be different now.
This view was corroborated by a borrower on the panel who recalls being in New York the day Federal Reserve Chairman Jerome Powell publicly indicated that the Fed funds rate should rise by 50 instead of 25 basis points to control inflation. “If I had always been a trader, my reaction would have been to short the 10-year Treasury. But the market went in the opposite direction,” he said. “It tells me that in addition to ignoring geopolitical risk, investors are no longer looking at the macro economy. This may sound cynical, but it offers great opportunities for issuers.
To their credit, public sector borrowers have done an admirable job of maximizing the opportunities presented to them in recent years, seizing the chance to lock in low rates and extend the maturity profile of their debt portfolios. .
This favorable funding environment has been created and maintained primarily by the liquidity floodgates opened since the global financial crisis. To put the size of this liquidity injection into context, one commenter noted that nearly three-quarters of central banks’ total assets, which amount to about $42 billion, have been accumulated since 2013.
The liquidity tap remains open today, despite the replacement of quantitative easing by quantitative tightening. “Yes, the ECB will act,” said one borrower. “Yes, QE in Europe will stop and move to QT. But we have a longer-term targeted refinancing operation which still amounts to 2.3 billion euros.
He added that reserve management is not just the responsibility of reserve managers. “Financial services regulation has forced commercial banks to maintain hundreds of billions of high-quality liquid assets, which has further boosted investor demand for public sector debt,” he said.
The reduction in order books for new public sector bonds is already a fact, but borrowers can easily live with it. “Issuers can no longer hope to generate £70bn books when they want to take €5bn off the market. Those days are over,” said one borrower. “But more than half of that demand was of very poor quality. Issuers should not be fooled by large numbers of oversubscriptions but should focus on the quality of the order book. The quality rather than the quantity of orders in the new issue market was one of the many reasons given by this issuer for remaining optimistic about its funding program.
Unfortunately for investors, the persistence of deeply negative real funding costs will militate against a growing supply of inflation-linked public sector bonds, which would at least provide them with some protection in today’s market. A summit participant suggested that sovereigns should consider pegged instruments as a way to help manage inflationary shocks. Another recalled that in the 1990s some speculated that building inflation exposure into their debt management strategies could inject some discipline into government spending, helping to contain inflation.
None of these arguments are likely to cut the ice for debt managers whose job descriptions require them not to protect investors’ returns, but to minimize their governments’ funding costs. Moreover, as one central banker put it, reserve managers are reluctant to buy inflation-linked sovereign bonds because of the equivocal signal they send: “If you invest in these instruments, you are essentially betting that your fellow central bankers will fail to meet their inflation targets,” he said.
A European pension fund manager on the panel drew attention to a number of underestimated or misunderstood long-term factors that he said would make the world more “accident-prone” for investors.
These included the accelerated pursuit of sustainability and the energy transition it will catalyze; continued geopolitical tensions driven by increased competition for scarce natural resources; innovation; and digitization of money.
But perhaps the most challenging of the long-term economic influences identified by this speaker is the demographic shift that will become increasingly visible as fertility rates fall. “We don’t age; there are fewer and fewer of us,” he said.
The results, he added, would be a faster-than-expected slowdown in global economic growth and fewer human resources needed to service sovereign debts. “These drivers will create a very different investment environment than what we have seen in the past few decades,” the panelist concluded.