The debt doom loop

Government bonds have been a poor investment in the last five years. $100 invested in a global bond index in January 2020 would be worth $95 today. Invested in UK gilts, it would be worth just $67. Factor in an increase in US and UK price levels of over 20% during this time and real returns on bonds are much worse. The same pattern holds for European government bonds.

It wasn’t always so. Between 2000 and 2020 government bonds offered good returns, easily beating inflation and, in the case of the UK and the euro area, outperforming equities. US bonds outperformed equities between 2000 and 2016. Thereafter returns on US equities roared powered by the tech boom.

Bond prices move inversely with inflation and central bank interest rates. The steady downtrend in inflation and rates in the first two decades of this century sent bond prices soaring and was a boon for bond investors.

The high inflation of the last five years has reversed that process, forcing central banks to raise interest rates to levels that have not been seen in more than 16 years. No one expects a return to the sub 1.0% level of interest rates that prevailed for over ten years, between the financial crisis and the pandemic.

Bonds have done badly in the last few years because markets think interest rates will need to run higher to control inflation. Investors have also become more nervous about rising levels of government indebtedness.

This is not really about the risk of governments defaulting. Governments, such as the US or UK which print their own currency, can always create more money to pay creditors. The greater real risk is that governments reduce the real value of bonds by running higher inflation. A subtler approach would be to use regulation and taxes to force the private sector to hold more government bonds or to reduce the return on bonds.

The borrowing numbers are not attractive. Even at a time when the West is growing many governments are running high levels of borrowing. Worryingly, much of this debt is being used to fund current costs, such as benefits and public sector wages, rather than investment. Governments are not households, but a rough analogy is that of a consumer using a credit card to finance everyday spending.

Borrowing to finance public investment, such as infrastructure, can raise growth rates and pay for itself. The same cannot be said of current spending. High levels of borrowing and rising debt risk a doom loop, with debt servicing costs eating up a rising portion of tax revenues, forcing the government to raise taxes to fund interest payments. In turn, heavier taxes weigh on growth and tax revenues, renewing the cycle.

It is easy to identify such risks and imbalances – and impossible to predict when, or if, they will turn into a full-blown crisis. In markets, as in life, timing is everything.

In 2010 Bill Gross, founder of Pimco, the world’s largest bond fund manager, memorably warned that UK government bonds were, “resting on a bed of nitro-glycerine”. Gross argued that heavy government borrowing and the possibility of sterling devaluation, “present high risks for bond investors”.

The logic was impeccable. Yet notwithstanding weak UK growth, a sharp fall in the pound after the Brexit referendum and high levels of government debt, UK bonds did pretty well over the ensuing ten years.

The final word goes to Ray Dalio, founder of the investment firm Bridgewater. He is willing and prepared to make predictions. His latest book, How Countries Go Broke, argues that the countries of the rich world are “in the late stages of their Big Debt Cycles” which, if “not controlled in some way, the probability of an unwanted major restructuring or monetization of debt assets… is very high – something like 65 per cent over the next five years”.

But if we stick to the current path worries about debt sustainability are almost certain to mount.