Wednesday 16 October 2019

Why a bond market bust would be bad for Ireland

Predictions of a bond market bust are bad news for heavily borrowed countries like Ireland, writes Dan White, as our debt-service costs would soar if the bond market collapsed

A trader at work in the ten-year US Treasury Note options pit at the Chicago Board of Trade. The US bond market has risen by 14pc since 2011 — and most other bond markets have also risen strongly over the same period Picture: Bloomberg
A trader at work in the ten-year US Treasury Note options pit at the Chicago Board of Trade. The US bond market has risen by 14pc since 2011 — and most other bond markets have also risen strongly over the same period Picture: Bloomberg

Dan White

Bond prices are soaring. This is good news for heavily indebted countries, such as Ireland, which can now borrow much more cheaply. But is the 35-year bond bull market drawing to a close and if it is, what will the consequences be for us?,

Cast your mind back to 2010 when the NTMA couldn't find buyers for Irish Government bonds at any price and we were forced to call in the Troika.

Six years on, things look very different.

Last week, the yield on the benchmark ten-year Irish Government Bond was just 0.41pc. Bond yields and prices are inversely related; the lower the yield, the higher the price and vice versa. This compares to yields of almost 15pc way back in the dog days of 2011.

The Irish Stock Exchange's ISEQ index of Irish Government bonds has risen by 47pc over the past five years. This has been very good news for Franklin Templeton's star bond trader Michael Hasenstab, who made an estimated €5.6bn profit buying them at the bottom of the market in 2011.

While the rise in Irish Government bond prices (which were trading at close to bankruptcy levels in 2011) has been exceptional, most other bond markets have also risen strongly over the same period.

The German bond market is up 24pc, the UK bond market has risen by 41pc and the American bond market by 14pc since 2011, according to figures compiled by Bloomberg.

These increases in bond prices capped a bull market that started in 1981, when the then Fed chairman Paul Volcker hiked US interest rates to over 20pc in his successful campaign to reduce American inflation.

But is the bond bull market over? Paul Singer, whose hedge fund firm Elliot International manages more than $26bn (€23bn) of assets, definitely thinks so.

Writing recently to clients, Singer said: "Today, six and-a-half years after the collapse of Lehman, there is a bigger short cooking. That bigger short is long-term claims on paper money - ie: bonds."

While the views of Singer, whose firm led the holdouts that forced the Argentinian government to shell out $2.4bn to emerge from default earlier this year, are certainly worth considering, a word of caution is necessary. When it comes to predictions of an end to the bull market in bonds, we have been here before.

Three years ago, Bill Gross, then the head of the world's largest bond fund, PIMCO, proclaimed: "The secular 30-year bull market in bonds likely ended on April 29, 2013." It hadn't and Gross lost his job shortly afterwards.

When it comes to calling the end of the bull market in bonds, economist Paul Samuelson's old quip about markets predicting nine of the last five recessions springs to mind.

That said, it is hard not share at least some of Paul Singer's concerns about where the bonds markets are headed.

"Bondholders… continue to think," he wrote, "that it is perfectly safe to own 30-year German bonds at a yield of 0.6pc per year, or a 20-year Japanese bond (issued by the most thoroughly long-term insolvent of the major countries) at a little over 1pc per year, or an American 30-year bond at scarcely above 2pc per year."

The ECB's policy of quantitative easing - buying €80bn of bonds every month - has led to some very strange outcomes. On current trends, the ECB will own 25pc of the eurozone bond market by early next year. It has already had to broaden its purchase criteria to allow it to buy corporate, as well as government, bonds.

QE has also pushed up eurozone bond prices and squeezed down yields. Not alone are Irish Government bonds trading at record low levels, a quarter of the entire eurozone bond market now trades at negative yields - ie bondholders are paying governments to borrow their money.

The gross borrowings of the Irish State stood at €197bn at the end of July, according to the NTMA. While the good news is that our borrowings (which are virtually unchanged since the end of 2014) have stopped rising, the bad news is that they are still very high.

With the 'Leprechaun economics' phenomenon having rendered traditional yardsticks, such as debt as a proportion of either GDP or GNP, largely meaningless, the NTMA has had to look around for other measurements of Irish debt sustainability.

Its favourite measurement is now gross debt as a proportion of annual government tax revenues, which currently stands at 285pc. This compares to an EU average of 189pc and a figure for Germany of just 159pc. Based on these numbers, Ireland's borrowings are still somewhere between 50pc and 80pc higher than they should be.

It may seem counter-intuitive but large borrowers, such as Ireland, are much more vulnerable to interest rate movements when rates are low (as is now the case), than high. This is because when rates are low, even a relatively small increase in rates results in a far greater proportionate increase in the total interest bill than when they are high.

The average interest rate on Ireland's debt is currently about 3.4pc and interest payments gobble up 9.6p of total revenues. This means that a 1pc increase in the average interest rate on the national debt to just 4.4pc would increase the proportion of revenues going on interest payments to 12.6pc - while a 2pc increase to 5.4pc would push it up to over 15pc.

Such an increase in the cost of servicing the national debt would eliminate the scope for tax cuts or other politically desirable goodies.

So why doesn't the NTMA refinance more of our existing borrowings to lock in the current low bond rates, before they start to go back up again?

If only life were that simple. When a bond matures, the NTMA repays bondholders at par. However, if it buys back bonds before they mature, it has to pay the current market price.

Take the case of the 2025 Irish Government Bond, which has a coupon, or nominal interest rate, of 5.4pc. It is currently trading at €142. So the NTMA would have to pay €142m for bonds with a nominal value of just €100m.

This means that any interest savings would be offset by an increase in the nominal value of the national debt. We in this country can only hope that Singer's predictions of a bond market bust prove to be as inaccurate as previous forecasts turned out to be.

Sunday Indo Business

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