Why do Governments Default?
We hope that everyone has continued to try and find their own personal silver linings during these turbulent times. As states begin their re-opening plans and the COVID-19 shutdown is gradually ending, we hope that you share our excitement at the prospect of more normalcy in our lives. Governments have been defaulting for centuries. In 1345, King Edward III, defaulted on the England’s loans to finance what became the 100 Years War with France. This bankrupted two of Europe’s biggest banking families, the Peruzzi’s and the Bardi’s of Florence, clearing the way for the rise of the Medici’s.
The basic reason for defaults is that governments become unable or unwilling to repay their debts. Countries that borrow in other currencies are at risk for devaluations of their own currencies. Argentina is preparing to default for the ninth time since it gained its independence in 1816, or roughly once every 23 years. With this track record, why would any investor want to buy their 100 year bonds? The 7.9% yield on Argentina’s $2.75 billion bonds that sold in 2017 proved too tempting in a low interest rate environment. Ultimately, devaluations of the Argentine peso and lack of economic growth resulted in the country's second default on its US denominated debt since 2001.
Over the past two centuries, countries have borrowed money without the slightest intention of paying back their debts. The last serious set of government bond defaults occurred in the 1930s, when the economic decline left countries and local governments without the ability to raise the taxes needed to service their debts.
This issue is important now because global unemployment has reached depression levels (20%+) in 10 weeks rather than the three years that it took in the 1930s.
While we all hope that business will rebound once the lockdown is lifted, it is clear that many industries, including retail, restaurants, travel, and leisure may require significant adjustments and take years to recover. The debts these businesses issued and the taxes they pay to support state and local government bonds are now at risk.
This comes at a time when outstanding global debts already reached $260 trillion, before the COVID-19 shutdown. These loans requires about 12% of global GDP just to pay the interest on the debt at current interest rates. Central banks have already planned to issue another $10 trillion in bonds. They have successfully suppressed interest rates for more than a decade and are expanding their balance sheets now as the primary buyer of these bonds. This expansion cannot continue indefinitely.
After 40 years of declining interest rates, we expect long term interest rates will begin to rise. The first indication is that interest rate spreads between high and low quality bonds are already beginning to rise.
While interest rate changes generally occur slowly, that could change quickly if the European Central Bank is unable to maintain its purchases. Negative interest rates in Europe and Japan have destroyed their traditional bond markets. There are no natural buyers of negative interest rate bonds. Traditional buyers, including pension funds and insurance companies, need interest rates of at least 6% to support their distributions or businesses. There is a big gap between what the central banks are paying and what traditional buyers may be willing to pay. 80 Hayden Avenue, Suite 110, Lexington, MA 02421 O: 781-890-5225 F: 781-890-5279 E: firstname.lastname@example.org For the bondholder, the risks are asymmetric. The upside is capped by the maturity value of the bond. The downside is open to both interest rate and credit risks. Interest rates may be significantly higher when investors realize it is a buyer’s market. Higher interest rates and weak economic growth are likely to produce more defaults.
What are the solutions? The traditional solution is to extend the maturity of the debt to spread the debt service out over time. This is what New York City did in 1975. Because interest rates are at such a low level today, this is not a viable option. A second solution requires bondholders to accept a lower principal amount and lower interest rates. Given the magnitude of the outstanding debt, however, there are other historical solutions worth considering.
The British financed the costs of the Crimean War and World War I with long-term government bonds. Following the devaluation of the pound in 1927, the UK consolidated all of these debts into a perpetual bond with no maturity (Consols) at lower interest rates to reduce the costs of servicing its debts. The consols kept investors locked into low interest bonds, which allowed the UK to slowly inflate their debt away. By the time the consols were redeemed in 2014, the real value of the principal had fallen by more than 99%. While it may seem unlikely, exchanging outstanding bonds with maturities for perpetual's offers a viable solution for overburdened governments.
The artificially low interest rates created by the central banks quantitative easing and bond-buying programs created a bubble in the global bond markets. The recent abrupt economic slowdown in the global economy creates an unusual and asymmetric risk of loss for investors. For those that must buy bonds, we recommend avoiding most government and municipal bonds.
While Keynes called gold a “Barbarous Relic,” the recent behavior of the central banks in rebuilding their gold holdings, as shown in the chart above, sends a decidedly different message.
This email is the last in this weekly series. We hope that you have enjoyed reading these and found them to be informative and helpful. As always, we welcome your thoughts and questions. Please stay safe and be well.
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