The spread of Covid-19 and ensuing lockdowns has meant governments around the world are taking on huge debt burdens to ease the economic burden caused by the pandemic.
Debt levels globally have hit a record high of $258trn in Q1 of 2020, according to the Institute of International Finance (IIF), and the impact of the pandemic and fiscal response have certainly contributed to the rise.
Indeed, data from the IIF show that global debt levels now account for 331 per cent of global GDP, but that percentage increased dramatically in the last year.
Jonathon Gregory, head of fixed income – UK at UBS Asset Management and manager of the UBS (Lux) Bond SICAV - Global Corporates fund, pointed out that this trend of increasing debt was already well established even before Covid-19 struck.
“What is also apparent is that total debt is increasing at a faster rate than growth in the global economy, so overall leverage (in this case debt relative to global output) is increasing,” Gregory explained.
“For a long time now, adding debt to the global economy has not been of obvious benefit to the overall growth rate.”
This is because as more is spent on debt servicing, more debt can be a drag on growth.
He said the higher overall systemic leverage has been a factor in the need of central banks to keep interest rates low.
Indeed, the US Federal Reserve's target interest rate has been trending sharply lower for the last 35 years.
CHART OF FEDERAL FUNDS TARGET RATE OVER LAST 35 YEARS
Gregory noted: “As global debt levels have risen, not only is the overall trend sharply lower, but each peak in rates is lower than the last.”
The implications for bond market yields are that the same downward trend has been seen in the broader bond market yields.
The yield on the Bloomberg Barclays Global Aggregate Bond index yielded 5.6 per cent 20 years ago, but as of August this year it hit a record low of 0.8 per cent.
This falling bond yield has very important implications for future returns of bonds.
According to UBS data, between 2000 and the end of July 2020 the Bloomberg Barclays Global Aggregate Bond index produced an annual average total return of 4.6 per cent, but almost 85 per cent of this return came from income, when the starting yield was around 5.6 per cent.
CHART OF GLOBAL AGGREGATE BOND YIELD FROM 2000 to 2020
Therefore, with the 0.8 per cent yield in the bond universe today, the prospect for future broad-market bond returns over the next 20 years seems rather lower than the past two decades.
Additionally, the UBS strategist noted that it is extremely unlikely that the trend in yields will reverse anytime soon. Indeed, many governments need rates to stay low to ensure the impact of their massive fiscal expansion and Gregory believes central banks are “more than willing” to assist via asset purchases and policy rates nailed to the floor.
However, Gregory said a key point for bond investors today is that while overall broad market returns are likely to be lower than in the past, “different sectors of the market will offer quite different risk-reward characteristics over time”.
Therefore, the diminishing likely returns of a passive allocation to the bond broad-market should “alert investors to the need for active styles that embrace the widest possible opportunity set,” the strategist said.
Gregory laid out three possible outcomes to a world of low growth, high debt and low yields and the implications for investor bond allocation.
One outcome is a ‘Big Crunch’ scenario where low levels of growth coupled with more borrowing eventually ends in a debt deflation spiral.
He explained: “Low inflation or even deflation leads to high real costs of debt servicing causing companies and consumers to default on loans and mortgages which have become too large to manage.
“This in turn leads to pressure on the banking sector, leading to less lending and more insolvency in a downward spiral.”
He said that in this environment cash and high-quality government bonds are likely to outperform credit.
The second outcome is a ‘Big Bang’ scenario which would see government spending resulting in inflation which would in turn destroy the value of debt in real terms, but also the value of savings.
“This scenario isn't likely over at least the next year or so as the deflationary effects of Covid-19 predominate,” the strategist said. “It will become a much bigger risk if capacity constraints arise in economies where massive fiscal spending creates excess demand that ultimately forces up prices.”
In this scenario he thinks inflation-protected securities could do relatively well.
The third possible outcome would be a ‘Steady State’ one, where global growth exceeds the rate of global debt expansion, real growth accelerates and inflation goes up, but not too much.
“It's perfectly possible, but it would mark a break in some very well-established trends,” he admitted.
However, in his view, this would be the preferred outcome of policymakers, which likely result in credit and emerging markets becoming winners in this scenario.
He said that the end of the bond bull market is probably nearer than most expect, but exactly how and when it will unfold is still extremely uncertain.
“So, investors should critically appraise their bond holdings now to ensure they have the diversification and flexibility to thrive in what will be a very challenging world,” he finished.