speaking about matching terms of assets and liabilities, and rising interest rate trend
Global Market Brief: Feb 21, 2005
On Feb.18, Agence France Tresor, the agency responsible for managing
the
French government's debt, announced that it would begin offering
50-year
bonds within the next week with an initial launch worth 3 billion euros
($3.9 billion). While multiple countries in Europe have been
considering
such an offering, France has taken the lead. Others will follow. The
move is
a signal that Europe is preparing for higher interest rates on a
generational scale.
Demand for longer-duration assets has been rising steadily in Europe in
recent months, with calls coming primarily from pension fund managers,
insurance companies, banks and asset managers. Institutions such as
banks
and insurance companies are always looking for reliable long-term
revenue
streams, which is why they applauded the French announcement. The more
recent demand has other sources.
One, with pensioners living longer and pensioner savings increasing,
lower-risk longer-term assets can help better fund retirements and
provide
revenue streams. Two, recent changes in pension fund management rules
in
multiple countries requiring a more exact match between assets and
liabilities make longer-term securities offering reliable cash flows
well
into the future attractive.
On the supply side, historically low interest rates in Europe mean that
the
costs of borrowing are essentially as low as they are going to get.
Governments will not get a better deal than they will by nailing down
current interest rates for the next five decades. In this context then,
it
is not surprising that someone decided to roll out a 50-year offering,
and
it is less surprising that France was the first to do it.
If the Germans provide the benchmarks for existing European bonds, the
French are the trendsetters. The have often been a step ahead of the
game
with respect to innovative bond offerings, and they certainly have the
motivation with their chronic budget deficits.
With plenty of demand from institutional investors and low borrowing
costs,
France is likely to be first in a line of European governments opting
for
the 50-year bond that will include Germany, Italy, the Netherlands and
the
United Kingdom. All four are considering issuing the ultra long-term
securities for the reasons cited above -- and all four will be watching
the
outcome of the French offering closely.
Particularly in the case of the leading eurozone economies -- Germany,
France and Italy -- a new means of raising money with repayments far
down
the road is desirable; it would help to keep them within the limits of
the
eurozone's growth and stability pact. The pact mandates a maximum
budget
deficit of 3 percent, and Houdini himself could not wave an accounting
wand
powerful enough to make these serial offenders appear to be within its
fiscal boundaries. The bonds represent a means of raising money that
will go
into the coffers now and reduce deficits while the vast majority of the
expense will occur years down the line.
While 50-year bonds look like smart borrowing to shore up existing
budget
gaps, there will be long-term ramifications should they proliferate
throughout Europe, as appears likely. Smart borrowing is still
borrowing,
and the more a government borrows, the more upward pressure it creates
on
interest rates due to supply and demand factors.
When a government issues new bonds, the available supply of debt is
increased. Without a concurrent rise in demand, the government is
forced to
offer higher yields -- in the form of higher interest rates -- to
induce
investors into buying. Issuing 50-year debt ensures that there will be
more
debt on the markets over the course of the next 50 years, and interest
rates
will need to increase in order to compensate. Higher interest rates are
certainly inevitable for the eurozone down the road, but borrowing on a
50-year time scale is going to raise the floor beneath interest rates
across
generations for future borrowing.
Most eurozone bond offerings now max out at 10 to 15 years, with the
exception of the U.K. in which longer offerings of up to 30-years are
more
the norm. By announcing the sale of 50-year bonds, France is also
declaring
that it is prepared to deal with somewhat higher interest rates over a
long
term measured in decades. Any country that follows France's lead will
be
agreeing to the same.
Critics say that the 50-year bond will do little that the 30-year bond
does
not in terms of their sensitivity to interest rate fluctuations and
their
tradability. This is because the value of bonds of either time frame is
far
more dependent on whether or not a country is going to exist in its
present
incarnation 30 or 50 years down the line than it is on gross domestic
product (GDP) growth rates or interest rates. This is highly probable
in the
case of eurozone countries, which have already been around for more
than a
century or three.
Critics add that the longer term bonds will diminish the value of
30-year
bonds, which will cause prices of the 30-year securities to fall and
yields
to rise. This is precisely what happened following the French
announcement.
Critics argue this will leave a portion of the bond market with longer
term
bonds that are more difficult to trade given the longer time frame and
problem of projecting further into the future. A less flexible bond
market
would be unable to allocate money as efficiently, which would lead to
an
overall reduction in available financing for the economy.
All of these criticisms, and others, might be valid. From the
perspective of
European governments today, however, any potential problems associated
with
longer-term bonds can be dealt with in the future. With all the
existing
incentives in place, it is too much to expect a government to pass up
the
opportunity for cheap borrowing.
Specifically for France, beating the competition to the punch in
issuing the
longer-term bonds will bring rewards. With growing demand for 50-year
bonds
and no other available supply, the French will be able to offer lower
yields
for higher prices relative to those that any other European government
that
might follow in their footsteps will offer. They will reap the greatest
benefit, but it appears there will be plenty remaining for their peers. |
