With governments in the U.S. and Canada, among others in the developed world, having issued mountains of debt to bail out their economies from the impact of COVID-19, are these nations’ bonds still safe for investors’ portfolios?
One of the key causes for concern is that the U.S.‘s US$25-trillion total federal debt is predicted to be 105 per cent of that country’s estimated gross domestic product; Canada’s federal debt is on pace to exceed $1-trillion for the first time and will account for 49 per cent of this country’s estimated GDP. There’s a risk all this debt become unsupportable.
Today’s ultra-low interest rates make carrying that debt and making payments on federal and other government bonds affordable, but when those rates rise, governments will be stressed to pay their bills. For now, bond investors are willing to accept the trade-off of weak economies and a safe haven for their cash. If the weakness lasts for years, so will low interest rates. It’s a devil’s bargain, but one that bond investors are willing to accept.
That bargain is tenuous, though. If global debt markets perceive that the U.S., Canada or any other nation is headed to deadbeat status, its sovereign bonds would be sold off. Bond prices would fall, and banks, life insurance companies and pension funds would find themselves out of compliance with regulations that require them to maintain reserves – always in government bonds – in relation to assets and be forced to call in their loans. Businesses would then be forced to shut down as banks call their loans and the world would go into a major depression.
For now, credit-rating agencies such as Moody’s Investors Service Inc. and S&P Global Ratings Inc. are maintaining their AAA rating on Canada while Fitch Ratings Inc. demurred, lowering it AA+.
The consensus among economists is that the vast expansion of government debt will be covered by economic growth when it returns. In economic theory, if GDP growth picks up, then the money borrowed will have been well spent, says Chris Kresic, head of fixed income and asset allocation and portfolio manager, fixed income, at Jarislowsky Fraser Ltd. in Toronto.
“Increased GDP will pay the bill,” he explains. “Central banks are helping [to foot the bills for] recovery. The base for ownership of the debt is widening and there’s no doubt that the U.S. Treasury will pay its bills.”
The dramatic expansion of U.S. Treasury debt includes purchases of corporate debt exchange-traded funds by the U.S. Federal Reserve Board, which has invested billions of dollars into iShares IBoxx $ Investment Grade Corporate Bond ETF (LQD-A) and Vanguard Short-Term Corporate Bond ETF (VCSH-Q). In terms of quality, the swaps are good for credit markets. Short-term, investment-grade diversified corporate bonds present little default risk, U.S. Treasury bonds present even less.
The U.S. government’s efforts to pump up the economy and to keep commercial banks with bad loans from failing has a drawback. Collateralized loan obligations (CLOs) are close cousins of the collateralized debt obligations (CDOs) that almost brought down the U.S. banking system in 2008. CDOs were towers of debt built on crummy residential mortgages; CLOs are the same, but with lousy business loans instead of home mortgages.
U.S. banks hold US$250-billion of CLOs, 67 per cent of which is B-rated, subinvestment grade debt from companies such as Bob’s Discount Furniture and California Pizza Kitchen. The ledger value of these assets makes up the underbelly of commercial banking. One subinvestment-grade CLO issuer, Party City, recorded CLOs with a nominal value of $719-million.
Some wreckage in bond markets is inevitable, but governments can rescue lenders, says Avery Shenfeld, managing director and chief economist at CIBC Capital Markets in Toronto., noting that governments can take on this bad debt without limit.
“Governments never repay debt. They just roll it over,” he says.
It’s a confidence game, but, so far, the markets have confidence in governments.
James Orlando, senior economist at Toronto-Dominion Bank in Toronto, says that “if governments around the world swap private debt for government debt, then exchange values will remain the same.”
In fact, central banks are using a variety of measures to add to their balance sheets, so debt-to-GDP ratios are rising in major nations. In principle, if all major central banks swap private debt for public debt, as they are all doing, then no one currency will crumble.
Repayment of all the debt governments are taking on is not the issue investors should focus on. Rather, it’s the value of bonds held to dilute equity risk in their portfolios – and that’s no longer a question of credit quality, but of the presumption all major governments will act alike in increasing their debt loads.