The macroeconomic environment has been somewhat unpredictable for fixed income, particularly government bonds, in the past few years.
Ultra-low interest rates across the developed markets, with the European Central Bank making two cuts so far this year to reach 0.05 per cent in September, has meant bond prices have been on the rise.
Meanwhile, the macroeconomic situation in Europe has been gradually getting worse, with the Asset Quality Review and banking stress tests delivering a result that saw 25 banks fail.
Anthony Doyle, investment director within the fixed interest team at M&G Investments, pointed out in a recent post on the Bond Vigilantes blog that this failure did not trigger any kind of upheaval in the bond markets, as the banks that failed were expected to do so.
However, he adds that while the capital shortfall identified by the stress tests was measured at just ¤7bn (£5.5bn), an amount that seems manageable, the “scary” part of the results could be found in a table identifying the bad debts on the banks’ balance sheets.
“When the European Banking Authority applied its definition of non-performing exposure, rather than the commercial banks’ own internal definitions, bad debts skyrocketed by 18.3 per cent to ¤879.1bn. This equates to almost 9 per cent of eurozone GDP,” Mr Doyle explains.
“What terrifies us about the bad debt revision is that non-performing loans are a lagging indicator. Things are probably far worse than ¤879.1bn of write-offs. And with the eurozone possibly sliding into deflation and flirting with recession, we have to wonder whether bad loans will top the ¤1trn mark in the not-too-distant future.”
These figures combined with the latest Geneva Report shows global total debt-to-GDP ratio, excluding financials, is still growing rather than reducing; with the research suggesting the total debt has increased 38 percentage points to reach 212 per cent in 2013. It points out much of this increasing debt burden has been driven by emerging markets, particularly China, since 2008, but it warns that the lack of deleveraging across the globe is concerning.
The report states: “The ongoing poisonous combination of high and rising debt and the slowdown in GDP growth is a source of concern for debt sustainability, as well as for any prospect of sustained global recovery.”
While this may seem a theoretical point, the impact on fixed income investors – should the global recovery continue to stall – could be felt in terms of both prices and yields.
Although Legal & General Investment Management strategist Christopher Jeffery notes that, while the ‘neutral’ or ‘terminal’ interest rates in the US, UK and eurozone have dropped by more than 100 basis points in the past three quarters, this does not necessarily signal a gloomy economic outlook.
He says: “The decline in terminal rates can be seen as the product of rising appetite for savings, declining appetite for investment and portfolio shifts that have favoured debt over equity. The shifts in savings and investment have depressed the cost of capital, but are broadly offsetting in their impact on capital formation and therefore growth at the global level.
