Are sovereign-debt defaults are a natural conclusion to our current path, Joseph Mariathasan asks
Imagine there’s no risk-free debt. It’s easy if you try. That may be a shocking idea to many, but it may also be a source of liberation – there would be no hell beneath us, above us only sky (to paraphrase John Lennon).
Such a situation would not be in anyone’s LDI models. Yet some investment managers have the strong belief that government sovereign-debt defaults are a natural conclusion to the current path on which we find ourselves. US president-elect Donald Trump even announced in a CBS interview earlier this year that, if the US economy “crashed,” he would offer to pay creditors less than what they were owed. “You go back and say: ‘Hey, guess what? The economy just crashed. I’m going to give you back half’.”
As a self-proclaimed consummate deal maker, he is well experienced in renegotiating debt. Some now argue that it is not only the US, but the euro-zone, the UK and ultimately most of the world’s governments that are going to default on their debt. That will certainly be a source of worry – but a recognition of that possibility might also lead to a less blinkered view of the relative merits of investing in near-zero or even negative-yielding government debt, and equities with yields of more than 3% with built-in inflation proofing.
There are, of course, lots of different ways of defaulting. The Greeks do it in a very simplistic way by not giving the money back, but you can do it by inflation or by restructuring. In Japan, the idea has even been floated of issuing a zero-coupon perpetual.
If the world moves to an environment where governments do start defaulting in debt, the characteristics of sovereign debt change dramatically. Government bonds would become a much more volatile asset class, and equities would be able to hold their own against that kind of choice of investment classes. The idea of default risk in euro-zone and UK government debt removes a key plank of the intellectual foundation of the doctrinaire approach to LDI.
The premise of a doctrinaire LDI approach is that it is purely a risk-management problem rather than an investment problem. It is predicated on the idea there is a legal requirement to pay out a fixed set of cashflows.
The problem is how to ensure those liabilities can be met with as much certainty as possible. As pension schemes become more mature, they can be paying out 6% or more of assets every year – well in excess of yields available on any asset – so they have to redeem capital effectively.
That creates the risk that they are selling assets when the market has fallen, forcing them to crystallise a loss. Not many schemes are able to ignore that issue, which is the reason for ensuring future cashflows can be matched with certainty through government bonds. As a result, for the majority of pension funds, it is the mark-to-market valuation of equities that matters and not the dividend stream. If, however, there is default risk in government bonds, the mark-to-market volatility of sovereign debt will increase, as it no longer represents a risk-free asset. Comparisons with equities then become a trade-off between income and volatility, even if the issue is a risk-management problem.
Given the low government bond yields, pension funds will be trying to find sources of secure income other than government bonds. Whether that pushes them as far as some types of equities is the question. In theory, there are some listed companies where the equity just looks like a slightly subordinated corporate bond.
But quality or low-volatility companies have performed very strongly, just like bonds themselves. The market is already giving high valuations to listed tobacco companies, utilities and so on that do offer a low-risk income stream when bond yields are at record lows. Pension funds may have little choice but to look again at equity income streams and their characteristics. In any case, investors are rapidly running out of bonds in certain markets given the rate of central bank purchases.
At a basic level, the market value of equities tends to be about twice as volatile as dividend streams. Concentration risk, though, is also a problem, with the 10 largest dividend-paying companies in the UK making up 55% of the total value of dividends paid out by the FTSE 100, and the total sum of dividends paid out by Royal Dutch Shell, BP and HSBC representing one-third of the total value of dividends in the same index.
What the UK experience shows is that investors using equities for dividends should be taking a global approach. Investors seeking dividends do have some factors going in their favour. Parts of the market that traditionally have not been dividend-focused, such as Japan, are now paying records levels of dividends.
Where global-equity dividend strategies become even more powerful is at the individual level, where there is more flexibility to take on a limited amount of volatility. With annuity rates driven to low levels by government bond yields, it makes less sense for individuals to purchase annuities that disappear on their death, rather than income-producing equity strategies that can be passed onto their children.
That also holds true for deferred beneficiaries of defined benefit (DB) pension schemes. It can be a ‘no brainer’ for many to cash in a DB scheme, essentially priced off current, historically low bond yields, and put the proceeds into a portfolio of equities with much higher dividend yields.
This should increase the actual pension payments substantially, albeit with increased volatility, and also leave a lump sum their children can inherit. The only issue may be, can they do so before president Trump’s policies drive up bond yields and inflation and drive down the value of deferred DB schemes?
Joseph Mariathasan is a contributing editor at IPE