Debt and demographics: The value of government bonds

14th November 2011

As such, government bonds have a relationship with demographics. One Mindful Money reader writes: "There must be a consideration of the bond-issuing country to pay back the principal when it falls due – even if there may not be a firm commitment to hold for that period, as the early resale value of the bond would also depend on the country's capacity to pay in full when due.

He suggests that those countries with weak demographics are therefore particularly vulnerable: "Looking at the (UN) population projection for Italy it's likely that between now and 2025 will see a nominal 10% drop, with a further 10% from then to 2050. This, coupled with the projected ageing of the population will result in a (probably significantly) lower tax-take than current. Why would a bond investor buy long-term Italian bonds without the inclusion of a large risk premium? Perhaps with this rise in yields we are just seeing the result of this projected future, and that the Euro issue is mixed up in the reality."

This is a theme taken up by FT Alphaville. It examines proposals here, by a former Moody's employee, Marc Joffe, who looks at an alternative approach to valuing government bonds.

Joffe says: "I propose a different modeling approach for advanced economies that focuses on their primary risk factor: the impact of population aging on social insurance spending. The approach leverages the wealth of budget, economic and demographic data and forecasts available for these countries."

FT Alphaville says in response: "The basic idea is that these ratios can be more predictive of the risk of default than the default (gettit?) debt-to-GDP figure, since they embed information about the government's ability to tax its economy and the level of interest rate it pays on its bonds. If you do decide to look at interest expense-to-revenue ratios, then, you just need to figure out how the figures are historically related to default.

"Likely with things like aging it will be necessary to make a clearer distinction between durations. A lot of countries will be at a cost peak because of aging within the duration of a 30 Year bond. But for a 2 year there will not be any problem. The 30 year bonds will likely face difficulties as governments are usually much too late with measures."

Older populations

This alternative approach would be bad news for countries with weaker demographics – Japan, Italy, or even the UK. However, Jenna Barnard director of retail income at Henderson Global Investors says that this relationship has not necessarily held true in the past. She says: "As populations get older, they tend to hold more fixed income. Obviously this increases demand and pushed up prices, so it tends to be good for bonds. Look at the example of Japan, which has already gone through this sort of change. Old people need income and therefore tend to move to bonds. For now, there is always a new generation of older people coming through."

However, she admits that the situation is slightly less clear-cut at the moment because people are able to pick up big dividend yields on equities.

There is also the problem that the relationship has held through times of credit expansion. Weak demographics may hinder a country contracting its debt burden and may therefore work against it improving its credit rating, albeit indirectly. Ageing populations mean high social security and pension bills. Either way, at some point weakening demographics at some point create an additional pressure on a highly indebted country. Italy faces longer-term problems even when its current crisis is over.


Stop press: Reuters reports on Monday that Italy did manage to attract investors for its latest auction of sovereign debt, but the price paid for the 10 year bonds of 6.29 per cent has unsettled markets. While that figure is less than the peaks of the last few weeks, analysts believe it is not sustainable long term. Markets continue to doubt whether the administration of Italy's new technocratic Prime Minister Mario Monti can set Italy back on a sustainable course.


More from Mindful Money:

Vision of Britain: The future of the UK economy

Investment perspectives: The language of the crisis

Italy in the spotlight – but do its problems spell insolvency?

Government Bonds: Are they about to make a come back?

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