The Hidden Risk to Sovereign Bonds

It's no longer inflation; annulment is looking like the bigger risk.

Bondfire of the JGBs?

Photographer: ED JONES/AFP/Getty Images

The Bundesbank dropped something of a bombshell this week. The eurozone's most influential central bank and the guardian of all things sacred to monetarists, suggested that sovereign bonds should contain clauses that would automatically delay repayment to investors for countries in financial difficulty. Not paying on schedule may not be the same as default, but it won't feel much different to bond investors. They may have to get used to it.

With almost $10 trillion of the world's debt securities paying less than zero, investors chasing ever-lower yields risk losing a ton of money if borrowing costs start to rise. But there may be an even bigger risk brewing in the fixed-income markets -- what if governments decide to cancel the bonds owned by their central banks?

QuickTake Negative Interest Rates

In theory, erasing the money that a national Treasury owes its own central banks would have no effect on the government IOUs owned by private investors. In practice, though, it would look very much like a first step on the slippery slope to debt restructuring, which is a polite way to talk about sovereign defaults.

And, much as quantitative easing, negative interest rates and helicopter money have all moved from the fringes of policy discussion to the mainstream of economic discourse (even if helicopter money has yet to be tried), the idea of debt cancelation is starting to gain some traction.

Bond investors are already suffering from "something of a mass psychosis," according to Jeffrey Gundlach, who oversees $102 billion as the chief executive officer of Los Angeles-based DoubleLine Capital. An astounding 10 percent of bondholders says that "yields are never going to rise," according to a Bank of America survey of 72 global fixed-income money managers. And this month offered a real-world example of how that kind of hubris might backfire.

The benchmark 10-year German government yield climbed 103 percent last week (that is not a typo). By close of play on Friday, the rate had climbed to 0.006 percent, after ending the previous week at -0.189 percent. So anyone who owned the 0.5 percent German bund repayable in February 2026 saw the value of their investment slump to 105.37 percent of face value from 106.68. That's a price loss of 1.22 percent, which is a big loss; bonds, remember, are supposed to offer safety.

Moreover, if the German yield returns to the 0.5 percent level prevailing at the start of the year, the price would drop back to face value -- a loss of more than 5 percent. Here's how Jim Grant described the risks in the most recent edition of his "Interest Rate Observer" newsletter:

The notion that negative-yielding bonds, denominated in a fiat currency, are a `safe' asset is a misconception that belongs in the next edition of `Extraordinary Popular Delusions and the Madness of Crowds.' We are bearish on bonds, especially the ones that, like new cars on a dealer’s lot, positively guarantee the owner a loss as soon as he takes possession of his property.

The bond market is telling us that there's little prospect of an acceleration in consumer prices that would erode the value of future returns -- hence record-low borrowing costs around the world. So governments whose debts have ballooned can't rely on a dose of inflation to ease those burdens. David Zervos, the chief market strategist at Jeffries in New York, also reckons that the failure of negative interest-rate policies, zero-interest rate policies and ever-greater quantitative easing programs will eventually tempt governments to eliminate their obligations by simply rejigging their balance sheets:

The endgame for this global foray into unconventional monetary policy is sovereign debt destruction. If the central banks cannot generate enough inflation to reduce the real sovereign debt burden via ZIRP, NIRP, QE, and QQE -- an outcome that looks increasingly likely -- then they will simply destroy the debt directly, in a `bondfire.'

Adair Turner, chairman of the Institute for New Economic Thinking and a former head of Britain’s financial regulator, made similar comments to Bloomberg News last month regarding how Japan could mend its finances:

I do not believe that there is any credible scenario in which Japanese government debt can be repaid in the normal sense of the word `repay.' It would therefore be useful to make clear to the Japanese people that the public debt does not all have to be repaid, since some of it can be permanently monetized by the Bank of Japan.

Japan has a debt-to-gross-domestic-product ratio of about 230 percent. Increasingly, though, that debt is owned by the central bank rather than bondholders. Martin Schulz, a senior economist at the Fujitsu Research Institute in Tokyo, has calculated that at the current pace of purchases, the debt holdings of private investors will have almost halved since the end of 2012, dropping to 100 percent of GDP in the next two to three years.The rest will be with the Bank of Japan. 

Billionaire bond investor Bill Gross also sees those central bank holdings as vulnerable to being annulled. Here's what he told Bloomberg Television's Erik Schatzker in May:

At some point Japan will basically buy up all its debt and the central bank will forgive the Treasury and try to move forward with that. I see no other way out for Japan.

If the idea of a government arbitrarily imposing new conditions on the market for its debts sounds far-fetched, note that some sleight of hand by the Federal Reserve more than half a century ago did just that. When World War II ended, the U.S. central bank found its independence challenged because of an agreement with its Treasury to cap bond yields and borrowing costs. As a January 2015 paper by Harvard finance professor Carmen Reinhart and IMF economist Maria Belen Sbrancia explains, U.S. bondholders found themselves press-ganged into holding securities that took longer to get repaid and for which there was no secondary market. Marketable bonds were exchanged for non-marketable bonds (bonds that the holder could not sell) at a much lower coupon and longer time to maturity. It wasn't quite a default; but I bet it felt pretty uncomfortable for the investors who found themselves held hostage.

Zervos at Jeffries said in a research report earlier this month that the bonds held by the world's central banks are unlikely to ever make their way back onto the market:

I would argue that this debt has already permanently disappeared from the private markets -- it's just that most people don't realize it yet. Central bank bond purchases represent something one government agency owes to another government agency.

On the surface, canceling the debts owed by one government department to another may well look like a case of no harm, no foul. And extending bond maturities for a struggling euro zone country may look far preferable to a taxpayer funded bailout. But it's not a big leap to not getting paid at all. In its current febrile state, if the bond market gets wind that any government is about to start playing fast and loose with its balance sheet, there could be hell to pay.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.