The Looming Bubble in Long-Term Debt
In the aftermath of the financial crisis of 2007–2009, analysts and prognosticators have constantly argued over the next big bubble. Will it be in auto loans, in equities, government bonds, or even in housing again? However, the biggest risk facing financial markets may be the financial asset duration bubble. Since 2009, large institutions including central banks, sovereign wealth funds, pension funds, and insurance companies have acquired longer-dated assets to achieve needed returns on yield. Years of monetary policy stimulus from the world’s major central banks has suppressed interest rates worldwide to all-time lows. While this may be viewed as a stimulating policy for borrowers, it creates serious issues for financial institutions with required levels of investment returns and with future liabilities.
What is Duration Risk?
Pension funds and insurance companies invest in assets that pay a yield, which can include coupon payments on fixed income securities (like US Treasuries or corporate bonds) as well as price appreciation over time, in order to “fund” their future liabilities. A pension fund, for instance, must ensure that they achieve a certain level of returns (often as high as 7 percent) in order to fulfill the promises made to their employees when they retire. When interest rates fall, the present value of these unfunded obligations starts to rise — because they are “discounting” this future obligation with the market rate of interest. The lower the interest rate used for the discounting, the higher the value of the liability (or asset).
Insurance companies must do the same, in order to be prepared to pay out varying types of claims depending on the line of insurance they operate in (property & casualty typically has shorter-term payouts than life). As a result of this artificially low interest rate environment, which has been running for almost 8 years now, these incredibly important institutions have very high duration risk on their balance sheets. “Duration” is simply a measure of an asset’s price sensitivity to a change in interest rates, with longer-maturity securities having much higher duration than shorter-term ones.
While longer-dated bonds may provide higher coupons and overall yield, the other end of that double-edged sword is that they represent a massive danger should rates start marching higher. According to Bloomberg’s index, the effective average duration of the global bond market currently is 6.98 years. This is considered uncomfortably high by historical standards. Goldman Sachs, for instance, forecasts that a simple 1 percent increase in interest rates could inflict $1.1 trillion in losses to the Bloomberg Barclays U.S. Aggregate Index, representing a larger loss for bondholders than any other time in history! This figure doesn’t include other forms of securities such as bank loans on company balance sheets or interest rate derivative contracts. The institutions mentioned above hold many of the assets that comprise this index — and thanks to years of monetary policy stimulus we have a major duration bubble on our hands.