International Investing

Low rates brought on by a flood of liquidity has compressed credit spreads to absurd levels. Todays WSJ article about the few billion of Indonesian bonds being marketed next week gives an example:

Anything longer than 10 years is good, and the longer the better,” said a syndication banker at a U.S. bank. “The curve is flat and spreads are at ridiculously tight levels. Markets welcome long-dated paper.”
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Yesterday morning, the most active 2017 and 2035 bonds were trading at yields of around 6.2% and 6.7%, respectively, according to a Singapore trader.

A US 30 year, currently yielding 5%, giving a 170 bps spread over the Indonesian bonds, shows that investors are not demanding much of a premium to hold these risky bonds. An observer might wonder;

What are these buyers thinking?

Excluding hedge funds, the buyers of this paper, pension funds and insurance companies, care more about the long dated nature of the bonds than the risk premium they get. They have to match assets and liabilities - they are buying the bonds because they NEED to not because they want to.

Part of this is legislative, a reaction to the Pension Protection Act in the US and the creation of the Pension Protection Fund in the UK. This undated Futures Industry Association article explains:

The story starts with the efforts by policymakers in Washington to force pension funds to more accurately report their assets and liabilities.
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The idea behind these efforts is that disclosing the true mark-to-market state of pension plan funding will encourage corporations to insure that their pension assets and liabilities track one another more than they have historically. If they do not match assets to liabilities, then a host of interested parties shareholders, auditors, regulators, and even plan participants would see that funding ratios (that is, the ratios of assets to liabilities) often swing wildly as the present value of liabilities goes in one direction while the value of assets go another.

What can a responsible pension funds do? Clearly they are going to buy up everything they can regardless of yields. By the time it blows up it might not even be their problem anymore. The problem is billions of dollars are chasing the same strategy - there are simply not enough long dated bonds to go around.

Here is what is available:

And here is what is needed:

So how bad is it (Lehman duration is ~6 years)? Over 300% more 20 year + bonds are needed:

There isn’t an easy answer but there are plenty of idiotic ones, like this one from the FT:

Many economists have urged the government, through the Debt Management Office, to flood the market with long-dated index-linked gilts to increase supply. To reduce demand, they have called for a decisive break between the discount rates used to value pension fund liabilities and the assets in which a fund might choose to invest.

So the possible solutions are: Flooding the market with gilts that have a nearly negative yield or rejiggering the numbers so that the unchanged liabilities will no longer show up in the accounting. Those are delaying tactics - not solutions.
Alan Greenspan warned that, “history has not dealt kindly with the aftermath of protracted periods of low risk premiums”. Market participants have yet to learn that lesson.