While rising government deficits and debt are concerning for many bond owners, they should actually be more concerned that deficits aren’t big enough, said David Bezic, an independent economic consultant, during a session at Benefits Canada and the Canadian Investment Review’s 2020 Plan Sponsor Week in mid-August.

Many of the concerns around debt and deficits are founded on misconceptions, he noted. “These misconceptions arise because it’s a natural tendency to apply our personal experience to our analysis. And, when we look out at the world, we apply our own budget constraints, our own financial situation to other entities when it might not be entirely relevant. Then also, some of these misconceptions just result from a misunderstanding of the way the money system actually works at an operational level.”

Read: Will social bonds’ popularity grow with coronavirus recovery?

As an example, Bezic noted the idea that a government defaulting on debt or being downgraded will impact bond yields is based on a misconception that puts currency issuers into the same bucket as the people who use the currency.

Currency issuers include countries with their own currency that also have debt denominated in that currency, such as Canada and the U.S. “Just as a scorekeeper can’t run out of points, a currency issuer can’t run out of money,” he said. “And just as a scorekeeper, by not putting up points on the board early in the game, it doesn’t mean that there’s now more points left to add later in the game.”

As such, governments have flexibility that other entities don’t have. Pointing to 10-year bond yields between 2008 and 2010, Bezic noted the U.S. had lower bond yields than Italy throughout the earlier part of the decade even through a downgrade and continued to decline afterwards. However, Italy, which is a currency user, saw higher yields.

When the European Central Bank introduced certain funding programs, yields in Italy started coming down because the programs meant Italy became more like a currency issuer, he added. “Basically, what they did is, they provided financing to banks and they allowed banks to use sovereign government’s debt as collateral for that financing. So that’s a kind of indirect way of making Italy backed by the ECB.”

Read: Currency considerations as plan sponsors grapple with volatility

Bezic said practitioners should be mindful that credit risk is real for issuers and suggested they keep an eye on developments that make currency users more like issuers.

He also highlighted that government deficits actually add assets to the private sector’s balance sheets. “[Government bonds] sit on the asset side of our balance sheets and they’re the result of deficits. If it wasn’t for deficits, we wouldn’t be able to own all those bonds.”

Typically, people view deficit risk growing too big as a risk, he noted. “But when you recognize that they’re the source of the bonds that you use to manage either pensions or various funds, the real risk is that there just aren’t enough bonds.”

For example, Australia saw a series of surpluses in the early 2000s and wasn’t issuing bonds. As a result, large investors became concerned about supply and put pressure on the government. “[The Australian government] did an official review and . . . the conclusion . . . is that successive governments have committed to retaining a liquid and efficient CGS market — which are their national bonds — even in the absence of a budget financing requirement. What this basically meant is they were still issuing bonds even though they were running surpluses.

“And that is an example that really highlights the value and the role that risk-free assets play. If you don’t think about where they come from, then you’re more likely to vote for prudent government and smaller deficits, but you’d just be reducing the supply of these assets that we all use and want so much.”

All of the 2020 Plan Sponsor Week sessions are available on-demand at benefitscanada.com/webinars.

Read: Which global bonds to consider in today’s interest rate environment

Copyright © 2020 Transcontinental Media G.P. Originally published on benefitscanada.com

Join us on Twitter

Add a comment

Have your say on this topic! Comments that are thought to be disrespectful or offensive may be removed by our Benefits Canada admins. Thanks!

* These fields are required.
Field required
Field required
Field required