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David Fisher, Olivia A. Albrecht
In the three years since the collapse of Lehman Brothers triggered a global financial crisis, governments struggling to revive their moribund economies have inundated investors with a virtual tidal wave of sovereign debt. This flood of issuance has led many to wonder whether governments will ever be able to repay their debts – and to ask questions about the purchasing power of any repayments they do make. Crucially, it has also highlighted the urgent need for investors to reconsider traditional approaches to allocating their fixed income assets across countries and regions if they wish to avoid the ripple effects of the debt wave.
Drowning in debt
In the summer of 2009, PIMCO highlighted that governments were rapidly expanding their fiscal deficits in an effort to offset a collapse in private demand. Since that time developed country governments have run fiscal deficits unprecedented outside of wartime, and the predictable result is that their debt levels have reached epic heights. U.S. gross federal debt, which stood at 64% of GDP in 2007, exceeded 93% by the end of 2010; and even Germany’s debt-to-GDP ratio increased from 65% to 83% over the same period. Japan, a country that has for many years run one of the highest debt levels in the world, saw its debt balloon to 215% from “only” 179% three years earlier, according to Haver Analytics. While for the U.S. these exploding debt levels – and the lack of any credible plan for dealing with them – have resulted in the loss of its coveted AAA credit rating by S&P, none of the three has been punished by markets for their profligacy (as of yet); interest rates on U.S., German and Japanese government bonds remain at or near all-time lows.
From interest rate risk to credit risk
The “other” risk: financial repression
Though the debt wave of the past few years has thus far produced only isolated examples of outright sovereign default, we would highlight that failure to pay interest or principal in a timely manner is not the only way for a sovereign borrower to stiff its creditors; for investors in government bonds inflation and currency debasement have the potential to be just as costly as outright default. In the Roman Empire, one method used by over-indebted emperors attempting to address their debt burdens was coin clipping – reducing the amount of precious metal contained in each of their coins in order to stealthily debase the currency. In today’s world of fiat currencies, sovereign debtors need not resort to trimming the edges of their notes and coins; they have more elegant methods of financially repressing their creditors. Financial repression, a form of “default by stealth,” is a gentlemanly way for countries with fiat currencies to virtually pick the pockets of bond holders while still paying interest and principal in full. As a way of reducing debt, politicians may find it attractive compared to the alternative of inflicting pain on their constituents through tax hikes or spending cuts. Financial repression may take the form of artificially low – or even negative – real interest rates, unconventional central bank policies or the deliberate weakening of the currency. Although not technically events of default, such repressive policies will just as surely erode investors’ total returns. So while investors should be able to count on most of their sovereign bonds paying par at maturity, they may be disappointed at how little their future dollars, pounds and euros will buy.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Credit default swap (CDS) is an over-the-counter (OTC) agreement between two parties to transfer the credit exposure of fixed income securities; CDS is the most widely used credit derivative instrument. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2015, PIMCO.
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