Impending Recession: Fitch Says Negative Bond Yields Don’t Necessarily Support Sovereign Credit

Negative yields on long-dated government securities are more reflective of distorted market conditions than of stronger sovereign credit profiles, Fitch Ratings says. Lower interest service costs support sovereign creditworthiness, but this must be weighed against the impact of the economic conditions leading to lower yields and historically high government debt levels in a number of countries.

There are nine sovereigns with 10-year bonds that trade at market prices implying a negative yield to maturity. The nominal stock of government debt with negative yields is about USD $15 trillion. Last week the yield on Germany’s 30-year bond turned negative for the first time and the 10-year yield fell below -0.60%.

Falling yields reflect various related factors, including policy rate cuts by central banks following the Federal Reserve’s first cut in more than a decade last month, investor concerns about global growth, and a ‘flight-to-safety’ in financial markets after President Trump’s announcement of additional U.S. tariffs on Chinese imports.

Nevertheless, one reason for persistently low or negative yields is central banks’ continuing role in the bond markets. The Bank of Japan continues to buy JGBs as part of its yield curve control and Fitch thinks that weak growth and low inflation will prompt the ECB to restart net asset purchases in 4Q19, albeit at a relatively modest pace. The Fed said in July that it would end its process of balance sheet reduction two months earlier than previously indicated.

While lower government bond yields are generally associated with stronger sovereign credit profiles, Fitch thinks the latest moves are partly a continuation of the distortion created by Quantitative Easing (QE) over recent years. For example, sovereign ratings of countries that were Eurozone members in 2007 were downgraded by a collective 68 notches between 2008 and 2013 as the region was hit by the global financial crisis and the resulting rise in government debt, easily outweighing the six notches of upgrades.

Bond yields and spreads diverged from ratings in mid-2012 after ECB President Mario Draghi said the central bank would do ‘whatever it takes to preserve the euro’. The subsequent modest recovery in Eurozone ratings since 2014, as shown by some 14 notches of upgrades collectively (net of downgrades), has been outstripped by the dramatic reductions in bond yields and spread compressions.

Lower government bond yields can certainly support sovereign creditworthiness since they reduce the interest service burden which, relative to government revenue, is an input into our Sovereign Rating Model.

This effect is felt over time, however, as the average maturity of developed market government debt is usually relatively long, so that the effective interest rate and the annual debt service burden change only gradually. In the Eurozone for example, the average residual maturity is 7.4 years. Furthermore, the fiscal space created by lower interest service has in many cases already been absorbed by rising non-interest spending.

The economic conditions leading to structurally lower yields may not be as supportive of sovereign credit. Lower interest rates to some extent reflect weaker potential GDP growth stemming from slower productivity growth and demographic changes. These, along with low inflation, will adversely affect growth in government revenues and put upward pressure on accelerated spending, adding to fiscal challenges. Market distortions from QE also imply that the differential between interest rates and growth, which have been favorable for government debt dynamics, will ultimately rise again in the long term, making debt reduction a more acute policy challenge.