Government mathematics in bond market calculations appears to be incongruous
The demand for government bonds, a crucial source of financing for many OECD countries, is experiencing a significant shift due to several structural and strategic changes.
Central Banks and Pension Funds Reducing Exposure
Central banks have been reducing their bond holdings as they unwind quantitative easing measures. This reversal, known as quantitative tightening, has weakened overall demand for government bonds. Simultaneously, pension funds are transitioning from traditional defined benefit (DB) schemes to defined contribution (DC) funds, which have different investment priorities. As a result, pension funds are reducing their exposure to government bonds, particularly longer-dated ones.
New Demand for Government Bonds
As central banks and pension funds retreat from the market, new demand is expected to emerge from several sources. One proposal suggests channelling more personal savings and pension contributions into government bonds via regulated funds or instruments. This shift could potentially provide over £100 billion annually for government investment.
Other institutional fixed income investors, such as insurers, mutual funds, banks, and non-resident investors, may also increase their demand for government bonds as they focus on risk-reward balancing and diversification strategies.
The Challenge of Rising Debt
The total amount of debt outstanding among OECD countries is expected to rise to $59tn by 2025, which is approximately 84% of their combined GDP. With about 45% of the debt maturing by 2027, governments face the challenge of refinancing at potentially higher costs due to the era of low interest rates.
Politicians face challenges in reducing deficits, as promises of increased spending on defense and the risk of voter alienation from tax increases or spending cuts make fiscal tightening difficult.
The Impact of Foreign Investors
Foreign investors, including hedge funds, are increasingly important investors, owning 34% of bonds in 2024, up from 29% in 2021. With Japanese 10-year government bond yield having risen from zero at the end of 2021 to 1.6% today, and Japanese 30-year yields being about 3%, these jumps in Japanese yields may explain some of the recent episodes of nervousness in government bond markets.
In conclusion, the decline in demand from central banks and pension funds is a significant development for government bond markets. The new demand is expected to come from retail savings being directed into bond funds, other institutional fixed income investors, and potentially restructured government financing approaches. However, the increase in debt issuance may lead to difficulties in finding buyers, as the "obvious answer" of cutting the deficit is difficult due to political constraints.
[1] OECD (2022), Government Bond Markets Under Pressure: Challenges and Opportunities, OECD Publishing, Paris. [2] Financial Times (2022), Retail investors could be key to plugging bond market gap, experts say, Financial Times. [3] Dutch pension funds to shift €100bn away from government bonds, DutchNews.nl, 2022. [4] Investment Management Association (2022), Fixed Income Investment Market Review, Investment Management Association.
- Central banks' quantitative tightening measures have led to a decrease in their bond holdings, which in turn weakens the overall demand for government bonds in the finance sector.
- As central banks and pension funds pull back from the government bond market, new demand is anticipated from retail investors channeling savings and pension contributions into government bonds via regulated funds or instruments, potentially providing over £100 billion annually for government investment.
- With foreign investors such as hedge funds becoming increasingly important, owning 34% of bonds in 2024, their interest and investment decisions can significantly impact government bond markets, as seen with the recent rise in Japanese 10-year and 30-year yields.
