Issue: December 2012 / February 2013

Government debt will depress real returns on bonds

This year it has become increasingly apparent that, given the extent of the developed world’s government debt mountain, investors will be affected by measures to overcome it for many years into the future.

To better understand how this could potentially impact on financial markets and investors, our asset allocation and investment teams conducted intensive research into how financial markets have responded through history to similar challenges. We looked back as far as 1900.

In summary, we found that such high ratios of debt to gross domestic product (gdp) can be resolved in one of four ways: 1) high gdp growth, which would result in a drop in debt as a percentage of gdp and an increase in tax revenue; 2) a massive default on commitments; 3) an implicit default via inflation; and 4) austerity measures, which would imply fiscal discipline and we believe also financial repression as adopted by the US after World War II (a policy mix that governments employ to channel funds to themselves).

Based on our analysis, however, we expect the latter scenario to prevail i.e. governments continuing to rely on austerity programmes and financial repression to surmount their debt obligations in the long term.

Sanlam Investment Management
(SIM) chief investment officer
Gerhard Cruywagen tracks history
to look forward.

Cruywagen ...austerity impact

Austerity is achieved through fiscal discipline – higher taxes and lower government spending. Meanwhile, financial repression occurs when government intervention and regulation of capital markets increases so that they can channel savings into government debt and thereby fund their significant debt obligations. These periods are usually characterised by low or negative real interest rates.

Given the magnitude of the developed world’s governments’ direct and contingent liabilities, we believe it will take a long time to achieve a sustained improvement in government debt levels via austerity measures. As a result, governments are likely to continue promoting policies that result in financial repression – maintaining downward pressure on real yields for an extended period.

In light of this, we recently decided to reduce our long-run realreturn assumption on long-term fixed-rate interest-bearing assets to 1% on global assets. Given it is a global crisis and SA is unlikely to escape these trends, we simultaneously reduced the real return we expect on local bonds to 2%. These long-run real required return assumptions are integral to SIM’s pragmatic value investment philosophy because they help us determine the underlying intrinsic value of assets. The numbers we use are based on historical realised returns but also take into account relative risk considerations.

US government debt-overhang

As a result of our decision to reduce the long-term real returns we expect from bonds and the recent weakening in bond yields, we reduced our underweight exposure to domestic bonds in early November after increasing it in July when SA 10-year long bonds were yielding 6,8%.

However, given the huge debt challenge confronting governments around the world, investors would be well advised to lower their expectations for long-term fixed interest returns.