A 40-Year Veteran On Today’s Unique Bond Market Challenges
August 30, 2016
by Robert Huebscher
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Roger A. Early, CPA, CFA, is executive director and head of fixed income investments at Delaware Management. He is executive vice president and co-chief investment officer of Delaware’s total-return fixed income strategy.
Roger rejoined Delaware Investments in March 2007 as a member of the firm’s taxable fixed income portfolio management team, with primary responsibility for portfolio construction and strategic asset allocation. He became head of fixed income investments in February 2015. During his previous time at the firm, from 1994 to 2001, he was a senior portfolio manager in the same area, and he left Delaware Investments as head of its U.S. investment grade fixed income group.
Bond Market Challenges
I spoke with Roger on August 22.
You’ve written about the debt “supercycle,” which you’ve described as a buildup of government debt over the last 30 years that will drive lower growth in the U.S. and globally. What that means for fixed income investors and why is it about to unfold now?
The current-events version of this is the buildup in debt in recent years. McKinsey did a study recently citing the idea that indebtedness globally has increased by $50+ trillion since 2007. Its numbers were $142 trillion in 2007 and $199 trillion as recently as 2014. There are no signs that that trend has changed. The buildup, predominantly in government debt, continues up to this moment.
It’s important to stop and go backwards to better understand what we’re suggesting is at hand. The debt supercycle, in a broad sense, is not just current events. It refers to the process during most of the postwar period and certainly since the 1960s and 1970s, as opposed to prior to World War II, when economies were allowed to go through failures. Debt was allowed to fail and you went through a period where there was some washout. Then you started again – a renewal if you will. The debt supercycle is nothing more than a series of periods where the authorities — governments and the central banks — have reflated the economy every time we’ve seen either economic or financial problems. A couple of cycles ago corporate debt was the problem. We reflated the economy so that we didn’t have massive defaults on the corporate side and off we went.
The most recent example was the post-NASDAQ bubble. The Federal Reserve under Chairman Alan Greenspan reflated the economy in order to protect us from its follow-on. He directed the reflation into the housing-borrowing market; the debt market in housing was where we got a bubble. Since then we have reflated through the creation predominantly of government debt.
This is not something that started in 1999 or 2000. Go back to as far as the oil problems in the early 1980s, or the high-yield debt problems and the savings and loan problems in the late 1980s. Each time the process was, “Don’t allow the failures to carry on. Reflate the economy. Protect the economy. Protect the investor base.” It meant we pushed out another level of debt. We have lived under that process for many years.
You get to the point where the only parties who are borrowing in a bubble-like form right now are governments. It would appear as though we have to be near the end of this debt supercycle, because there is nobody to reflate that debt if the governments are the ones that are indebted. On top of that, at least when we were funding high-yield, oil and gas or houses, there was some argument for the productive use of borrowing. But the government debt that we have seen taken down, to the tune of tens of trillions of dollars since 2007, has very limited productivity behind it. We are building the bubble of debt to a never-seen-before level and we are doing it on the back of virtually no productive outcome to its use.
The debt is very large and a headwind to economic growth. If you can’t take on additional debt, at some point you’re going to have to live like anybody would, within your means for a period of time, which means a lower level standard of living, rather than borrowing to create a higher standard of living. That’s the guts of what this is about.
How does the debt supercycle affect investing globally and in the emerging markets in particular?
You have to move from macro to micro and understand the nature of borrowing within different parts of the world – different countries and economies.
The emerging markets went through of their moment of fear in the late 1990s. There was a lot of corrective action and some pretty good behavior from the emerging markets after the Asian crisis in the late 1990s. There was a period of time where they ran their business pretty effectively. They were careful about debt.
That all went out the window sometime in the mid-2000 area. From 2005 to 2007, and certainly in recent years, the buildup in debt in the emerging markets is part of this story. It’s part of the debt supercycle going to the next level.
Emerging markets have better potential growth than the developed economies. They’ve got a younger population and more potential for productive population growth. They don’t have quite the demographic challenges that Japan or the United States face. But that debt buildup has definitely occurred. When you match that up with the decline in commodity prices, even though we have had a bounce in oil, we are still substantially off the peaks of energy and other commodity prices from several years ago. I worry about their ability to service the debt. If I had to take a guess where you will see an inability to service debt, the emerging markets are the most likely place to look.
Is it fair to say that some of the paradigms that have traditionally existed in the fixed income markets no longer exist? What are some examples of that?
Having been in the fixed income business for 40 years, I am on a very short list of people who were working in the business when rates were rising in the 1970s.
The core of everything is income. The paradigm that has completely changed is that, for most of the post-war period, we lived in a world where if you were earning 8% to 10% coupons and sometimes higher, even in the worst of years, you were likely to return something positive because it was hard to lose 6%, 8% or 10% worth of your principal to more than offset that income that you were getting, especially in higher-quality assets.
Move forward to today where the Barclays Aggregate Index is yielding less than 2% and its duration is about 5.5 years. Forget worrying about corporate bonds, spreads or credit risks. Forget all that. Just a flat-out half-percent rise in rates eats up more in principal than you are making in income in the AGG.
That’s the new paradigm.
Bonds used to be the ultimate absolute return product. I was going to make some money in one way or another. I hoped to make all my coupon, but at least in volatile times I could at least make something – the coupon minus some principal impact. Now you clearly have a marketplace where you can end up with a negative return. People have had to change the way they’ve invested to find a balance and a little bit of protection from negative returns.
Because yields are so low, the paradigm now is a lot of people don’t use bonds for safety anymore. They are chasing any yield they can get and taking risks that they shouldn’t. But they’ve got to find some income. The fear is you get to the end of a credit cycle, which you clearly will do at some point, and people will have stretched as far as they can to find yield or income, and they will have far too much credit risk. The result will look like a small version of a downturn in stocks, because that’s what you end up with if you take too much risk on the credit side.