Risk free assets ?

In its recent Global Financial Stability report, the IMF deplored the fact that risk free bonds were becoming scarcer at a time when regulatory pressure was increasing and forcing banks to hold safe assets. The report indicates that “the scarcity of risk free assets could lead to bigger short term volatility spikes and higher volumes of sovereign debt being purchased in what could be defined as a gregarious behavior”. The report goes on by saying that “the demand for risk free assets is increasing but that latter will become less and less available”. It also mentions that 16% of what is currently considered as risk free government bonds might no longer be so in 2016. In other terms, it is possible that 4% of “safe” public debt may no longer be considered as such after each passing year. Considering the growing debt of governments, we can ask ourselves whether those dark forecasts are not already too optimistic.

But what is safe? Is it the AAA or AA rating provided by rating agencies such as S&P and Moody’s? After 2008, we have realized that excessive dependence on such parameters could prove very costly. Does “safe” equal goodwill bonds issued by sovereign countries such as France, Japan, the United Kingdom or the United States? Perhaps but the political and social uncertainties in these countries do not provide an immediate sense of security and trust. Sovereign AA / AAA bond issuers will probably not default during the coming years but what real value is being offered to their bonds’ investors?

The Federal Reserve and other central banks are doing their best to maintain very low interest rate levels. But such highly stimulating monetary policy should only act as a mechanism to buy time in order for an economy to take necessary measures to achieve growth equilibrium. Structural and fiscal measures must be set during a window of opportunity that arises after a stimulating monetary policy period. Failure in achieving this creates market distortions and inadequate capital allocation. Using monetary policy indefinitely can become a poison for the economy and worsen the already bad circumstances.

The US and Europe must take advantage of the current low interest rate environment in order to apply the necessary structural changes that will heal their economies on a long term basis. Europe may have bigger needs but change is imperative on both sides of the Atlantic. It is undoubtedly difficult for politicians to adopt a legislation that cuts the advantages that they have already provided to their voters. This, however, must be done. But this has to be carried out in a way that does not unnecessarily deteriorate further the already bad state of the economy.

The significant extension of the retirement age, the reduction of future social advantages, and the elimination of deferred fiscal advantages will have long term consequences on the deficits without worsening the current economic situation. All this will require political courage but these measures must be taken. The new state treasurer of Rhode Island has extended the retirement age of public sector employees from 62 to 67 years. It is a significant change.

Carrying out minor changes such as extending retirement age by half a year is simply insufficient. It is remarkable that in France a politician campaigns by advocating reverse change such as setting retirement at 62 instead of 60

George M. Muzinich

Several things have been written on contagion risk during the past few years. Fear of risk contagion was the reason why the holders of private bond holders of the Irish bank’s debt have been dealt in full when Irish banks collapsed. The entire Irish population was forced to pay in order to allow private investors to make money on a transaction that happened to be not very risky. We don’t really believe in the term risk free transaction. It might be so in the short term but in the long term, there is a price to be paid by society as a whole. The contagion risk from the private sector has become a contagion risk from the public sector.

The European Central Bank has issued unlimited amounts of credit to banks at nominal rate of interest. These banks have in turn considerably bought local sovereign debt which is, according to banking accounting rules, “risk free”. In other terms, the ECB has strongly issued liquidity at the disposal of the private sector in order to finance the public sector. All this is good in the short term but if the structural and budgetary problems are left untreated, the whole sovereign debt will be under increased surveillance and will be more and more put back into question

A good first 2012 quarter has ended. The second one has started nervously on the financial markets. There has been fear that monetary stimulus was coming to an end and that quantitative easing measures (regardless of their form) would soon be a distant memory. Markets have grown dependent on interest rates near 0% in countries considered as safe. The simple indication that monetary policy might change is enough to violently shake financial markets. Corporate bonds have behaved very well during the first two months of the year. During March and the beginning of April, we have seen a very orderly consolidation without any excessive turbulence.

There has been no deterioration of the excellent fundamentals that continue to be the characteristic of corporate debt. The bond default rate remains very low at around 2% - 3%. The debt tenors continue to be extended with cash flows and balance sheets remaining very strong

George M. Muzinich

The financial contrast between corporations and governments remain striking. On the one side, we have strong and improving balance sheets while on the other side we have weak and deteriorating balance sheets. We can also oppose a careful long term consideration on financial integrity to short term political motivations and a weak financial probity. What is “safe” in these portfolios? Is it the long duration state bonds or corporate bonds?