No one knows what will trigger the next recession. Often, a downturn starts in the financial sector, when the value of an asset class suddenly falls and wise people agree, after the fact, that prices got too high and wrought financial instability.
Looking at the financial landscape today, there are some signs of trouble: the stock market keeps going up, venture capital may also be over-valued, and firms are highly leveraged. But if one asset class stands out for its high prices and potential systemic risk, it’s supposedly low-risk bonds issued by governments in the US and Europe.
These bonds, in the lingo, are considered “risk-free.” By definition, then, they shouldn’t be risky. But prices for these assets have gotten very expensive. If their prices fall, meaning that yields rise, borrowers used to a long period of benign conditions will struggle to refinance their debts. And since many investors don’t hold bonds to maturity, the price of the asset matters more than the regular income payments it provides.
It is difficult to say if it these assets are over-priced, let alone in bubble territory. Financial bubbles don’t have a precise definition. Some economists describe it as an asset—or asset class, or entire industry or market—whose price is higher than its fundamental value.
Price are driven by speculation, or the hope that a purchase will be worth more tomorrow than it is today. When this expectation reverses, investors sell, prices drop, the bubble pops, and financial carnage ensues.
With stocks, it is easier to define a bubble than with other assets. You can value a stock based on it’s projected dividends and potential for capital gains, compare it to the current price, and judge whether it is over- or under-valued.
Bonds are different, because their value derives from the stream of interest payments they promise and investors’ desire to avoid risk. This comes from regulations that require financial firms or governments to hold safe assets, the need for collateral, or the desire of foreign countries to manage their currencies. Sometimes, people also just want to park their money somewhere they can get a certain return because they think the alternatives are too risky. Thus, the price of safe assets are largely driven by the fear that risky assets won’t deliver.
Technically a risk-free asset is any instrument that delivers your financial objective with total certainty. If you want $500 today to turn into $505 next year, with no risk whatsoever, it could be a treasury bill that pays 1% interest or a money market fund with a similar guaranteed return. If you want to maintain purchasing power over a longer period, the risk-free choice is an inflation-linked treasury bond or its equivalent.
But since many investors are mostly concerned with preserving capital, risk-free assets tend to be things like treasury bills, which offer a certain return over a short amount of time and are easy to buy and sell. Before the financial crisis, risk-free assets included any bonds rated AAA, which included some mortgage-backed securities. Markets have rightfully become more suspicious of the risk profiles of these assets since 2008.
So, why have bond prices risen so high? Like anything, it comes down to supply and demand.
Some economists speculate there is a “safe asset shortage.” The demand is mostly coming from government that need safe assets both to manage their currencies and conduct monetary policy. Demand is also coming from financial firms that need safe assets to comply with regulations and for collateral, as well as pension funds that need to ensure they can pay their liabilities.
The demand for safe assets is global, and yet only a few countries produce genuinely safe assets. Developing markets are too risky, with volatile capital flows that disrupt their currencies and returns on their debt. This leaves big, stable economies, like the US, Germany, Japan, and others to supply safe assets for the whole world. The global economy is expanding faster than these large but slow-growing economies, meaning that the demand for safe assets outstrips the supply.
Normally, prices would adjust accordingly, with yields falling and prices rising until they reach an equilibrium. But there is probably a limit to how high risk-free asset prices can rise—or, put another way, how low or negative interest rates can fall. At a certain point, savers will just keep their holdings in cash. This creates a natural shortage that economists think (pdf) has made the global economy more interconnected and unstable.
If risk-free assets are at the center of a new bubble, it implies that safety is over-priced. This is a complicated concept. There are bond speculators who are betting prices will keep going up, a classic factor in a financial bubble. But to some extent, high bond prices are also driven by risk aversion. It might be that investors are too risk averse, over-estimating the amount of risk in the economy. But economists normally consider risk aversion a preference, and it is hard to argue that people’s preferences are wrong. It is also unlikely that risk aversion will suddenly disappear, the same way speculators suddenly lose faith in an asset.
Because a large share of demand comes from regulation and governments, politics also poses unique risks for risk-free assets. Foreign governments could lose their appetite for safe assets if they have political beefs with the issuers of those assets, or just develop a nationalist desire to invest locally. Alternatively, if we enter a beggar-thy-neighbor currency war, the demand for safe assets could increase even faster and cause more instability. When it comes to the bond market, political risk is paramount.
In either case, there is a chance prices will fall—eventually—but odds are it won’t be as fast as the implosions when risky asset bubble pop.
Even if there isn’t a sudden drop in price, a risk-free bond bubble may pose more systemic risk to the economy than a standard asset bubble. The risk-free interest rate is the foundation for everything, from mortgages to credit cards to the benchmark against which all investments are judged. If more saving drives safe rates even lower, this could require people to scale back their expected returns, which can mean less consumption, especially in retirement.
The Bank of International Settlements and Morgan Stanley’s Ruchir Sharma worry that low rates make it easier for companies that should go out of business to get loans and continue to operate. These so-called “zombie” companies may not sound so harmful, but too many of them can cause instability over time. If yields go up, many of these firms will suddenly go out of business at the same time and displace many workers. In the meantime, they also keep people in unproductive jobs and divert capital from more productive investments.
If the risk-free rate is too low, there are three ways to address it.
The first, obvious solution would be for governments to issue more debt. But it is not so simple. These debts will be around for a long time, and if rates may increase one day the borrowers will be stuck paying to refinance them. Safe assets exist because people think countries like the US won’t default or inflate away their bonds, but if their debts grow too large then markets may doubt the safety of these assets. There may be some room to issue more debt, especially if it pays for growth-enhancing projects like infrastructure, but there is a limit.
Another option is securitizing riskier debt, perhaps creating tranches of different risk tiers from less stable countries or private assets that aren’t considered safe right now. But, as we saw in the financial crisis, this poses hidden risks. The point of a risk-free asset is that it offers a certain payment in any market. The private sector and less stable countries’ debt don’t satisfy this condition.
Lastly, we can just wait. Odds are that eventually the risk-free rate will increase and it may be a gradual unwinding. Asian countries are slowly offering a viable alternative to Western assets and expanding the market for safe debt. Or, investors might rediscover their appetite for risk, reducing demand for safe assets. One way or another, rates will go back up some day. Until then, there is a high price to pay for removing risk from your portfolio.