Sunday 21 December 2014

Brendan Keenan: Understand one thing about bonds, none are totally risk free

Published 17/01/2013 | 05:00

THERE was a sad story, many years ago, about some unfortunate who bought supposedly risk-free government bonds with the money from selling a house while he looked for a new one.

Alas, by the time he found a new house, some political/ financial crisis had caused a 20pc fall in the value of the bonds.

We decided not to carry the story, interesting though it was. It was just too complicated trying to explain bond yields and how "risk-free" in this case did not mean no risk.

I doubt that I mentioned government bonds more than a couple of times in 20 years. They were really only of concern to professional investors. Now they are everywhere and it is going to get worse as the possible end of the bailout becomes the big story.

There could be no better person than the Governor of the Central Bank to tackle these arcane matters. Dr Patrick Honohan has form, having done considerable work as an economist on the differences in bond yields and interest rates between the Irish pound and other currencies in the days before the euro.

He referred to some of that earlier work in a thought-provoking speech at a conference last week organised by the Bank of International Settlements – the organisation which represents central banks.

He was talking about the unassailable fact that a lot of government bonds, including Irish ones, are no longer regarded as risk-free. As the ill-informed housebuyer found out, that never meant that their value could not go down, as well as up. It did mean that it was seen as almost certain that lenders would get their money back if they kept the bonds until the day the government had promised (its "bond") to repay the debt.

There is always some risk that governments will not keep their promise – that they will "default." The traditional measure of that risk is the difference or "spread" between the yield lenders demand from the countries seen as most likely to repay debts – historically the USA and Germany – and other, less favoured states.

Bond issue

In this month's much-lauded four-year bond issue by the Irish state, the spread over Germany was about 3pc. That represents a lot of risk but, as Dr Honohan said, we have been here before, albeit in somewhat different circumstances.

That was during what the governor called the "ill-fated" precursor to the euro, when currencies were supposed to move within narrow bands. Spreads reached 3pc then too. The fear was, not so much that Ireland would not repay its debts but that it might devalue the pound and the repayments would have less purchasing power.

Which is indeed what happened. The euro was supposed to put an end to such fears, and for a decade seemed to have done so. But the crisis created a double fear – not just of devaluation, which would require exit from the single currency, but default as well.

Looked at it this way, a 3pc spread over Germany seems small. It is hardly enough to cover that double-D threat – devaluation and default. The evidence is that markets are much less fearful of exit and devaluation but remain worried about getting all their money back on the due date.

Dr Honohan made it very clear that the ECB had the exit threat in mind when it introduced its "OMT" commitment to buy short-term government debt at prices which, in its opinion, do not include the risk of a euro beak-up.

Discipline

This "will ensure that disciplined governments will not have to pay spreads that could only reflect market concerns about a system breakup," he said.

So far, this seems to have worked, but Dr Honohan appeared to agree with the Government that the present spread over Germany is still too high if the risk of a euro exit has been removed.

Not everyone agrees. Certainly not, it seems, the Moody's rating agency, which still regards lending to the Irish Government as an unsafe investment, while the other agencies are scarcely falling over themselves to upgrade the country.

Despite Government and NTMA protestations, one can see the agencies' point. Even if one assumes that the risk of Ireland leaving the euro has been largely removed from the spreads, the risk of debt default for lenders certainly has not.

The agencies, along with any sensible lender, are not looking just at the GDP figure on which official debt ratios are based. If they take the compromise measure calculated by the Fiscal Advisory Council between GDP and GNP (let's call it gross taxable product), debt works out at 140pc of this GTP.

That is dangerously high and there is no point in beating about the bush and pretending it is not. Instead, the Government is beating the bushes themselves in Europe, in the hope of getting this figure, or at least the cost of it, reduced by deals on bank debt.

All of this is highly relevant to the prospects of Ireland returning to commercial borrowing next year. It is not just a question of how the economy performs this year, vital though that is. Given the levels of public and private debt, will the markets lend the large sums required enough at affordable rates?

What, indeed, are affordable rates? Everyone, including Dr Honohan, accepts that there will be no early return, if ever, to the very narrow spreads over Germany seen before the crash.

But the times, while they may be out of joint, may also be propitious for Ireland to take a bit of a punt on the bond markets.

German yields

With German yields close to zero, that recent €2.5 billion borrowing by the NTMA cost 3.3pc. That is below the historical cost of government borrowing over the past century.

In the midst of a crisis like this, there is always a tendency to think that the world will never be the same again.

But history says otherwise. It says that German yields will rise as the crisis abates. Irish spreads should also narrow in such circumstances, so the actual post-crisis yield may not change much.

It could even he higher. It is true that we have seen a lot of things happen which never happened before.

Even so, for a government to decline to borrow at less than 4pc, if that is available, could only mean that it sees no hope for the future.

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