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Equicapita Briefing - Rollover and Convexity Risk

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					Equicapita Update
July 2013
Equicapita Update




CENTRAL BANKING’S SCYLLA AND CHARYBDIS –
ROLLOVER AND CONVEXITY

The idea that the developed world, beginning with the US, might
just be contemplating a reduction to its unprecedented monetary
stimulus has shaken the confidence of investors. Clearly the die-
hard Keynesians at the Federal Reserve would like to have their
cake and eat it too in the form of artificially low interest rates,
real economic growth and no asset bubbles, but the market
increasingly seems to be in the mood to deny them nirvana.

While I believe that eliminating QE is the right thing to do for the
long-term health of the economy, the recent equity and bond
market declines are but modest harbingers of the unintended
short-term consequences that the Fed’s prolonged ZIRP/QE
program and its termination will wreak – rollover and convexity risk.
These are the proverbial pigeons that will come home to roost if
the US Federal Reserve stops its massive bond-buying spree and
rates normalize.

Sovereign borrowers have had unlimited privileges over the last
two decades. Those privileges are gradually being revoked as the
ability to repay is being called into doubt. Without the ability to
roll over their obligations at current historically depressed interest
rates, the truly precarious nature of sovereign finances will be
revealed. Consider that while interest rates for many developed
nations are at generational lows, sovereign debt loads as a
percentage of GDP are at all time highs.

The Scylla of our story today is what happens to western
governments when their borrowing costs go from 2% to
something approaching the long-term historical average of 5%?

In countries like Japan and the US, the answer is that the majority
of the budget would be dedicated to simply paying interest.
Perhaps this sounds alarmist and unlikely. But consider that, as
of 2012, US federal government debt exceeds US$ 15 trillion.
In 2011, the US government paid US$ 454 billion in interest (an
implied rate of 2.9%). The Congressional Budget Office notes

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Equicapita Update (continued)




that federal government debt will rise to US$ 20           number begs the questions: how will this maturing
trillion by 2015. If we assume that it carried a rate of   debt be re-financed and, perhaps more importantly,
5% instead of 3%, interest payments would total US$        at what interest rates?
1 trillion or 45% of current tax revenues.
                                                           Although the US bond market appears well bid for
According to a report by Incrementum “Even more            now courtesy of the US Federal Reserve, private
striking is the over-indebtedness situation in Japan.      lenders are not so sanguine. They are retreating from
As a result of the zero interest rate policy being         peripheral markets at the first hint of trouble. If this
in force for 17 years by now, the government has           continues, either the monetary authorities will have to
already refinanced the bulk of its debt burden at          continue to monetize maturing debt or interest rates
extremely low interest rates. Despite such favorable       will have to rise considerably from current historic
financing conditions, debt service costs already           lows. We have seen this on a relatively modest scale
amount to 25% of tax revenues. An increase of the          in the southern EU countries – what would happen if
average refinancing costs by three percentage points       this goes global (see the recent spike in yields in the
(to 4.6%) would consume the entire public revenue.”        US and Japan)?

Of course, these debt numbers understate the issue         I believe politicians have finally started to sense the
significantly. It is estimated that the present value      rollover end game is underway; hence the concern
of all future US expenditures (including such items        around keeping interest rates low by having central
as social entitlements and pensions etc.) less all         banks intervene in the bond market. But by keeping
currently contemplated future tax revenues, amounts        rates low over extended periods of time to allow
to more than a US$ 200 trillion deficit. Now imagine       financially constrained governments to roll debt
this is funded with debt carrying 5% interest, then the    at manageable rates central banks are forcing the
annual interest bills would be US$ 10 trillion or 500%     world’s fixed income investors to accumulate every
of current US federal tax revenues. Clearly, maturing      greater portfolios of low yielding bonds which leads
sovereign debt must continue to be refinanced at low       directly to the Charybdis.
rates for as long as possible otherwise state solvency
starts to come into question.                              The world’s monetary authorities have been engaging
                                                           in ZIRP for almost 5 years now. The longer this takes
Rollover risk can be defined broadly as the possibility    place the greater amounts of maturing, higher yielding
that a borrower cannot refinance maturing debt at          debt that are replaced, by necessity, with new
all or at least at rates sufficiently low enough to be     sovereign debt at historically low yields – according to
serviced. Here is a concrete example of rollover risk      Incrementum once again “in July 2012, 10-year yields
that may be unfolding right in front of us. By 2015,       in the US thus reached with 1.39% the lowest level
it is estimated that US$ 15 trillion (50%) of the debt     since the beginning of records in the year 1790. In
of the top 10 global debtors will have matured and         the Netherlands – which provide the longest available
must be rolled over. Considering that global GDP is        time series for bond prices – interest rates fell to a
estimated at US$ 70 trillion, the magnitude of this        496 year low. In the UK, ‘base rates’ are currently


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Equicapita Update (continued)




at the lowest level since the founding of the Bank of      complexity is not relevant to this discussion, simply
England in 1694. In numerous countries (Germany,           the concept that the current global bond universe
Switzerland), short term interest rates even fell into     is likely to have far higher convexity than the bond
negative territory.”                                       universe of the pre-ZIRP world.

In addition, with yields on shorter-term sovereign         In a nutshell this extra sensitivity to rate increases
debt virtually non-existent, bond investors (primarily     with its higher loss potential is the risk that the world’s
pension plans struggling to meet growing benefit           monetary authorities have created with their extended
obligations) have been forced to increase the duration     ZIRP programs by forcing bond investors into a lower
of their portfolios – chasing the marginally better        yield, higher duration, higher convexity universe–
yield, regardless of how minimal, of longer dated          arguably the most risky configuration possible. When
instruments.                                               rates normalize these investors in aggregate will suffer
                                                           the perfect storm of losses on underlying portfolios.
It is important to note that the bond market dwarfs
the public equity markets – sovereign debt is the          If you are still skeptical that pension funds could be
largest asset class in the world. So why the recent        at risk, a recent report by consulting firm Mercer on
panic over an approximate 70 bps move in US                the solvency ratio of Canadian pension plans should
interest rates, surely such a large asset class with its   provide some perspective. The solvency ratio of
pool of sophisticated investors is prepared to deal        the average Canadian plan fell by 7% in May and as
with such changes? Through the process of replacing        a consequence that most plans now had negative
higher yielding maturing debt with new debt at ZIRP        solvency ratios. The solvency ratio is “the amount of
distorted rates and at longer maturities in an attempt     money available to pay for earned benefits – known
to generate any yield at all, traditional bond investors   as liabilities under a plan – compared with the cost of
are creating portfolios of lower yield, higher convexity   buying annuities to cover those benefits in the event
and higher duration.                                       of an immediate plan windup.”

The issue of convexity is central to the crisis that       Recent yields moves were modest, imagine the
normalizing rates will bring to the pension industry.      losses that will stem from a return to historical
In very simple terms, convexity is a straightforward       average yields – arguably 300-500bps higher.
concept to understand – all things being equal, a          These losses cannot be avoided through financial
move from 1% yield to 1.5% yield causes a greater          engineering – someone has to suffer them. It will be
drop in the price of the underlying bond than a move       interesting watch to the world’s monetary authorities
from 7% to 7.5%. For the more mathematically               grapple with this conundrum – they can 1) continue
inclined – delta is the first derivative with respect to   QE and hope that the equity and bond market
yield (often referred to as the dollar value of a basis    bubbles do not come to a violent end or 2) stop QE
point and this is usually based on a $1MM notional         causing pension funds to suffer significant losses as
amount of a particular bond) and convexity is the          yields normalize which in turn will most likely trigger a
rate of change of delta with respect to yield. This        government bailout and more QE.


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