14th May 2012
Last week, the Bank of England held interest rates at 0.5% once again – the 36th month in a row. But despite firm forecasts to the contrary, there was no resumption of quantitative easing, the policy of printing money to help resurrect the UK's flagging economy.
This leaves conflicting signals. If no new money is printed, what weapons do the authorities still have to get the economy moving again? And will the forecast that interest rates will hold steady for at least two to three years from now be enough to maintain bond yields at their present record low levels?
This second question is crucial for investors who face a choice between a gamble on lacklustre equity markets or moving into bonds where yields fail to match inflation and the likelihood is a capital loss on redemption.
Why do investors put up with guaranteed to lose bonds?
Governments which print money and distribute the newly minted cash to banks and other institutions, have to ensure that there is a reason to buy their debt – after all, that is the whole point of quantitative easing.
There is no logical investment case to buy conventional gilts, or US Treasuries for that matter. The benchmark 10 year UK Gilt yields 2 per cent. Even before any tax might be deducted, this fails to keep up with actual rising prices – after tax it will fail to beat the Bank of England's 2 per cent inflation target.
And with the price set at £117.80 for each £100 to be paid on redemption, gilt holders must endure a capital loss when the bonds mature in ten years' time. It's a little better in US treasuries where the benchmark yields 1.88 per cent but the price stands just under par at $98.78 – leading to a tiny capital gain in 10 years' time.
But institutions pile into these deals despite their almost certain losses. Why? Governments manage to pull off this three card trick due to "financial repression" According to economists at investment bank HSBC, governments have to "find ways to rig the financial system to suit themselves." Government needs institutions to buy their debt – and as cheaply as possible even if it punishes the purchasers.
Pain for some will be a gain for a greater number
The trick is to force banks, insurers and pension funds to buy gilts even if it is not in the best interests of their ultimate investors. And the way to do that is to compel those institutions to take on government debt for regulatory reasons. Hence, liquidity, solvency and other factors can be cited to favour gilt purchases. And all have been tightened in intensity, ostensibly to prevent further financial crises although this increased balance sheet oversight failed to prevent US investment bank JP Morgan from losing a mere $2bn on investments designed to reduce overall risk.
Financial repression is, as HSBC points out, a way of "allowing governments to fund their borrowing through imposing costs on others. But even with printing money, there is always a limit on the amount of capital that can go around. If it is tied up in loss-making government bonds, it cannot be used to fund revival in the private sector.
And it is unlikely to make other investors happy. Financial repression forces funds into the bond market, away from equities – the government inspired changes which have effectively closed most final salary pension schemes have compelled funds to move from equities to bonds. However, it might be wrong to blame the go-nowhere equity markets of the last dozen or so years largely or totally on the economy as the lack of demand from formerly traditional retirement fund buyers has depressed share prices.
But Treasury enthusiasts argue that pain for some will result in gains for more -in any case, a good dose of repression prevents any thoughts of a southern European-style rise in interest rates.
Bubble dangers for bond investors
Pension funds and others who are repressed into buying know they will make a loss for their underlying investors. What they don't know is how much they will drop. It could be a lot more than they reckon.
They face an asymmetric risk where they should be able to work out the percentages involved in winning and losing but can't (or find it pointless) due to regulatory and other obligations to hold debt instruments.
Only if interest rates fall further – unlikely – or if demand for gilts rises due to the pressure from regulations, can the lossmakers turn a profit. This could work if the recession continues and the UK has a "Japanese" lost decade experience where the economy fails to revive no matter what is thrown at it. However, there is little room for further substantial increases in gilt returns.
But if the economy does revive in the future as the government which is selling gilts firmly insists will happen, then interest rates will have to increase at some stage. Interest levels even one point higher will knock a massive percentage from bond prices.
The probability of the first course are lower than the second so the chances are that
losses are on the cards. Investors risk a bond bubble – but one where many market players have no choice other than to participate.
However those who do have the option to avoid top graded bonds might prefer to look for other asset classes.
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