In 1167, the Republic of Venice became the first modern state to borrow from its citizens in a formal manner, taking a loan from 90 leading families. Within a few years the terms of such loans had been standardised; within a century a lively trade in tranches of the consolidated national debt was being carried on at the foot of the Rialto bridge. The global government bond markets had been born.
Over time, sovereign borrowing became a hallmark of economically advanced nations, and the most important means of affording citizens a share in the general prosperity. By the end of the 20th century, a vast financial infrastructure had been constructed, funding pensions, insurance and income. It was all built on the foundation of government bonds: the risk-free asset, with returns that rely not on the fortunes of any individual company, but on the health of the economy as a whole.
Since 2008, however, in the Group of 10 industrial countries the average yield on the benchmark 10-year bond has shrivelled from 4.3 per cent in mid-2007 to 0.5 per cent today. The hope after the crisis that growth and inflation – and with them bond yields – would recover has not been realised: nearly $12tn worth of government bonds trade at a negative yield.
No one knows exactly why. Some economists cite demographics, blaming shrinking working-age populations and pointing to Japan as the canary in the gold mine. Others argue that technological progress is the culprit, though whether too little or too much is not clear. A third explanation has monetary policy in the starring role: by experimenting with zero, even negative, policy rates, and implementing massive asset purchase and refinancing operations, central banks are artificially repressing sovereign yield curves.
The reasons behind ultra-low rates may be in dispute; the results are not. Government bond yields are not sufficient to fund the income liabilities at the heart of the developed economies’ financial systems. The average rate of return assumed by US public pension plans is between 7 and 8 per cent a year. The yield on even 30-year US Treasuries is 2.1 per cent. The gap sums up the great investment challenge of our era.
How can it be bridged? The preferred strategy has been to ditch government bonds and experiment with more exotic asset classes: investing in corporate bonds or structured credit instruments, or “alternative” asset classes such as property and infrastructure, even flirting with the equity markets via equity income products.
Such non-traditional asset classes have a role to play. But the recent “gating” of high-yield credit and property funds serve as a reminder that they involve tricky liquidity mismatches that make them unsuitable for many savers. In any case, these asset classes are too small to absorb the vast pools of capital devoted to G10 pensions, insurance and savings income.
Fortunately, a solution to the income problem is available. It is to stick to the asset class of government bonds, but to diversify much more thoroughly into emerging market sovereign bonds. These markets – unlike the G10 – are not in a coma. The unprecedented monetary policy experiments of the developed central banks are nowhere to be seen: if anything, emerging market monetary policy has become more, not less, orthodox
since the crisis.
There are exceptions, including China, and exposure comes with other risks. But by contrast to the G10, the economic challenges facing emerging markets are cyclical, not structural; and policy responses have been conventional, not experimental. Income-seeking investors can deal with a traditional asset class in jurisdictions whose volatility is no secret, rather than solutions that are fundamentally untested, and subject to policies whose risks are unknown.