July 10, 2013

Central Banking's Scylla and Charybdis - Rollover and Convexity

Guest post by Agcapita:

The idea that the developed world, beginning with the US, might just be contemplating a reduction to its unprecedented monetary stimulus has shaken the confidence of investors. Clearly the die-hard Keynesians at the Federal Reserve would like to have their cake and eat it too in the form of artificially low interest rates, real economic growth and no asset bubbles, but the market increasingly seems to be in the mood to deny them nirvana. 

While I believe that eliminating QE is the right thing to do for the long-term health of the economy, the recent equity and bond market declines are but modest harbingers of the unintended short-term consequences that the Fed's prolonged ZIRP/QE program and its termination will wreak - rollover and convexity risk. These are the proverbial pigeons that will come home to roost if the US Federal Reserve stops its massive bond-buying spree and rates normalize. 

Sovereign borrowers have had unlimited privileges over the last two decades. Those privileges are gradually being revoked as the ability to repay is being called into doubt. Without the ability to roll over their obligations at current historically depressed interest rates, the truly precarious nature of sovereign finances will be revealed. Consider that while interest rates for many developed nations are at generational lows, sovereign debt loads as a percentage of GDP are at all time highs.

The Scylla of our story today is what happens to western governments when their borrowing costs go from 2% to something approaching the long-term historical average of 5%?

In countries like Japan and the US, the answer is that the majority of the budget would be dedicated to simply paying interest. Perhaps this sounds alarmist and unlikely. But consider that, as of 2012, US federal government debt exceeds US$ 15 trillion. In 2011, the US government paid US$ 454 billion in interest (an implied rate of 2.9%).   The Congressional Budget Office notes that federal government debt will rise to US$ 20 trillion by 2015. If we assume that it carried a rate of 5% instead of 3%, interest payments would total US$ 1 trillion or 45% of current tax revenues.

According to a report by Incrementum "Even more striking is the over-indebtedness situation in Japan. As a result of the zero interest rate policy being in force for 17 years by now, the government has already refinanced the bulk of its debt burden at extremely low interest rates. Despite such favorable financing conditions, debt service costs already amount to 25% of tax revenues. An increase of the average refinancing costs by three percentage points (to 4.6%) would consume the entire public revenue."

Of course, these debt numbers understate the issue significantly. It is estimated that the present value of all future US expenditures (including such items as social entitlements and pensions etc.) less all currently contemplated future tax revenues, amounts to more than a US$ 200 trillion deficit. Now imagine this is funded with debt carrying 5% interest, then the annual interest bills would be US$ 10 trillion or 500% of current US federal tax revenues. Clearly, maturing sovereign debt must continue to be refinanced at low rates for as long as possible otherwise state solvency starts to come into question.

Rollover risk can be defined broadly as the possibility that a borrower cannot refinance maturing debt at all or at least at rates sufficiently low enough to be serviced. Here is a concrete example of rollover risk that may be unfolding right in front of us. By 2015, it is estimated that US$ 15 trillion (50%) of the debt of the top 10 global debtors will have matured and must be rolled over. Considering that global GDP is estimated at US$ 70 trillion, the magnitude of this number begs the questions: how will this maturing debt be re-financed and, perhaps more importantly, at what interest rates?

Although the US bond market appears well bid for now courtesy of the US Federal Reserve, private lenders are not so sanguine. They are retreating from peripheral markets at the first hint of trouble. If this continues, either the monetary authorities will have to continue to monetize maturing debt or interest rates will have to rise considerably from current historic lows. We have seen this on a relatively modest scale in the southern EU countries - what would happen if this goes global (see the recent spike in yields in the US and Japan)?

I believe politicians have finally started to sense the rollover end game is underway; hence the concern around keeping interest rates low by having central banks intervene in the bond market. But by keeping rates low over extended periods of time to allow financially constrained governments to roll debt at manageable rates central banks are forcing the world's fixed income investors to accumulate every greater portfolios of low yielding bonds which leads directly to the Charybdis.

The world's monetary authorities have been engaging in ZIRP for almost 5 years now. The longer this takes place the greater amounts of maturing, higher yielding debt that are replaced, by necessity, with new sovereign debt at historically low yields - according to Incrementum once again "in July 2012, 10-year yields in the US thus reached with 1.39% the lowest level since the beginning of records in the year 1790. In the Netherlands - which provide the longest available time series for bond prices - interest rates fell to a 496 year low. In the UK, 'base rates' are currently at the lowest level since the founding of the Bank of England in 1694. In numerous countries (Germany, Switzerland), short term interest rates even fell into negative territory."

In addition, with yields on shorter-term sovereign debt virtually non-existent, bond investors (primarily pension plans struggling to meet growing benefit obligations) have been forced to increase the duration of their portfolios - chasing the marginally better yield, regardless of how minimal, of longer dated instruments.

It is important to note that the bond market dwarfs the public equity markets - sovereign debt is the largest asset class in the world. So why the recent panic over an approximate 70 bps move in US interest rates, surely such a large asset class with its pool of sophisticated investors is prepared to deal with such changes? Through the process of replacing higher yielding maturing debt with new debt at ZIRP distorted rates and at longer maturities in an attempt to generate any yield at all, traditional bond investors are creating portfolios of lower yield, higher convexity and higher duration.

The issue of convexity is central to the crisis that normalizing rates will bring to the pension industry. In very simple terms, convexity is a straightforward concept to understand - all things being equal, a move from 1% yield to 1.5% yield causes a greater drop in the price of the underlying bond than a move from 7% to 7.5%. For the more mathematically inclined - delta is the first derivative with respect to yield (often referred to as the dollar value of a basis point and this is usually based on a $1MM notional amount of a particular bond) and convexity is the rate of change of delta with respect to yield. This complexity is not relevant to this discussion, simply the concept that the current global bond universe is likely to have far higher convexity than the bond universe of the pre-ZIRP world.

In a nutshell this extra sensitivity to rate increases with its higher loss potential is the risk that the world's monetary authorities have created with their extended ZIRP programs by forcing bond investors into a lower yield, higher duration, higher convexity universe - arguably the most risky configuration possible.  When rates normalize these investors in aggregate will suffer the perfect storm of losses on underlying portfolios.

If you are still skeptical that pension funds could be at risk, a recent report by consulting firm Mercer on the solvency ratio of Canadian pension plans should provide some perspective.  The solvency ratio of the average Canadian plan fell by 7% in May and as a consequence that most plans now had negative solvency ratios.  The solvency ratio is "the amount of money available to pay for earned benefits - known as liabilities under a plan - compared with the cost of buying annuities to cover those benefits in the event of an immediate plan windup." 

Recent yields moves were modest, imagine the losses that will stem from a return to historical average yields - arguably 300-500bps higher.  These losses cannot be avoided through financial engineering - someone has to suffer them.  It will be interesting watch to the worlds monetary authorities grapple with this conundrum - they can 1) continue QE and hope that the equity and bond market bubbles do not come to an violent end or 2) stop QE  causing pension funds to suffer significant losses as yields normalize which in turn will most likely trigger a government bailout and more QE.

Updates
Agcapita Farmland Fund IV Second Closing
Agcapita Partners is pleased to announce that Agcapita Farmland Fund IV will be conducting its second closing July 11.  Agcapita Farmland Fund IV is a $20 million RRSP eligible offering and is open to investors in BC, Alberta, Saskatchewan, Manitoba and Ontario and for the first time time Newfoundland. If you are an investor or a financial adviser interested in finding out more about the Fund IV offering please feel free to email us:

Cantillon's Curse: Stephen Johnston, the founder of Agcapita, has published his book Cantillon's Curse which is available on Amazon - it is a series of discussions on macro themes including:
  • stagflation;
  • demographics;
  • sovereign insolvency;
  • bailouts and the law of unintended consequences;
  • agriculture; 
  • EROEI; and 
  • the retreat of financialization among others. 
  
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