Economically speaking, Western civilization might be engaged in the most elusive search since the fabled quest by King Arthur’s knights to find the Holy Grail. The mythical grail was supposedly the chalice served at the Last Supper. Those who drink from it acquire eternal happiness and immortality according to legend. Today’s investors face a no less formidable or elusive quest. Investors are desperate to seek out quality sources of income at a time when central banks are intent on undermining them. High-quality sovereign debt denominated in US dollars may prove to be the closest thing to a financial equivalent of the Holy Grail. Given the current market climate, the return of your principal may prove more important than the return on your principal as the global economy braces for a significant slowdown or recession.
Conventionally, a bond is an interest-bearing contract between a debtor who pays interest for borrowing funds and a creditor who receives interest for lending the funds. In this Mad Hatter world which we now find ourselves, bonds can be interest-paying as well as interest-bearing. At the peak this summer, there was over $17 trillion in negative-yielding debt trading in international markets. Today, a debtor is rewarded with a recurring payment for issuing an obligation to pay principal at some future date. Meanwhile, the creditor must pay the issuer a periodic payment for the right to get their principal back at maturity. If this all seems counterintuitive, it is.
In this world turned upside down, homeowners should seek to obtain the largest mortgage balance from their bank to qualify for outsized monthly payments from the lender. A corporate borrower is unlikely to default on its obligations to receive coupon payments from bond investors. The corporate treasurer must now concern themselves with the counterparty risk of the investor.
Managed capitalism relies on and encourages the wrong incentives. True capitalism should discourage debt-financed demand rather than promote it, rewarding savers and penalizing debtors. Central bankers apparently believe that there is no zero bound or at least are not deterred by it. If there is a limit to monetary policy, we are there. The Japanese reached this point over 20 years ago. Europe reached it some ten years ago. Neither has been able to restore economic expansion solely with monetary chicanery. The U.S. now faces the prospect of the Federal Reserve following them into the abyss
Managed capitalism is failing to generate demand. The inducement of secular low rates is encouraging more debt creation. Such is precisely the opposite of what is needed. Even with low debt service, or the ability to earn positive cash flow from taking on more debt, the demand for loans is diminishing. Savers are too severely punished. Insurers and pension funds face obligations that will be impossible to meet. The unintended consequence of keeping the debtor out of bankruptcy may be to push the saver into default. It is also difficult to see how banks can remain profitable. The depositor may withhold funds rather than face the prospect of a negative return on their savings as rates become more negative.
The spread or relative difference between yields in the United States and the rest of the world is distorting the flow of capital. US dollar-denominated instruments represent over 90% of the income available to fixed-income investors globally. In US markets extended valuations reflect dollar demand rather than underlying fundamentals. Everything, from stocks and bonds to real estate investments, is inflated by an artificially low discount rate. At current levels of interest rates, investors can pick up yield by selling Treasury bonds and investing in the S&P 500 Index. Asset allocation models may soon suggest buying bonds for capital appreciation and stocks for dividend income.
Central bank policies are designed to move savers out on the risk curve as the absolute return for risk-taking is diminishing. As the “risk-free” rate falls and risk premia spreads narrow, the prospect of high returns from risk-taking is hopeful at best. Risk seeking is more aligned with the behavior of shunning traditional public market investments in favor of “alternative” private market investments which lack transparency, price discovery and liquidity.
High-quality sovereign debt denominated in dollars may seem unattractive in what is perceived to be a high return environment. The prospect of owning a coupon return seems unappealing unless there is principal risk associated with the alternative investment. Furthermore, when the coupon return is negative the appeal is further diminished. Today, the global bond universe is some $110 trillion, of which $93 trillion is interest bearing. Developed markets represent $85 trillion of this amount and half of that is corporate debt. Emerging market debt, all of which is interest-bearing, is only $25 trillion of the total debt outstanding. Most of the emerging market debt outstanding is denominated in local currency and/or issued by corporations. Only $1 trillion of the entire universe of global bonds offered to investors is sovereign, investment grade and denominated in hard currency.
The search for the financial holy grail need not be as difficult as it seems. This quest seeks high quality, transparent investments with price stability and discovery where valuations are not excessive. In an era of unattractive investment choices, the best path might be choosing what might first appear the least attractive. Look no further than hard currency, investment-grade debt issued by emerging market sovereign entities. There continues to be a premium for undertaking sovereign risk in the emerging versus developed world even though the fundamental differences between them are beginning to blur. Investor demand continues to expand as more allocators expand on the diversification benefits of broader asset class definitions. Finally, supply will remain constrained as emerging market countries continue to promote and develop local markets making them less dependent on finding funding sources in the hard currency markets.
To download the PDF version, click here: 2019-09 The Elusive Quest
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