Developments in the sovereign bond markets during the pandemic

By Andreas Charalambous and Omiros Pissarides

In the aftermath of the 2008 financial crisis, a number of analysts concluded that the yields of bonds of countries with diametrically opposed economic performance and policies had been allowed to converge perilously. As of now, we seem to be experiencing a similar scenario.

Specifically, the prolonged period of low interest rates, combined with the abundant liquidity provided by central banks and the expansionary fiscal policy stance of governments in response to the pandemic, have eroded government bond yields. As a result, traditionally robust economies, like Germany, are borrowing at negative interest rates, while even countries with long-standing structural problems are securing new debt at particularly favourable interest rates. Examples include China, which, for the first time, issued a sovereign bond carrying a negative interest rate at the end of 2020, as well as Turkey, which, despite its adverse economic predicament, managed to issue a five-year bond just two weeks ago with an interest rate of 5.125 per cent.

Although concerns about an inflation resurgence are intensifying, indicators reflecting long-term price development expectations remain broadly stable, indicating the markets’ view that interest rates will be contained at historically low levels for the foreseeable future. Especially in Europe, inflation trends do not seem to worry the ECB, which has not differentiated its quantitative easing strategy. In the US, inflation concerns are more pronounced pointing towards rising interest rates in 2023.

There are various problems that can occur.

First, public debt has expanded to very high levels. Although most analysts recognise the need to implement expansionary policies during the time of the pandemic, it should not be overlooked that lending eventually needs to be serviced or refinanced with, in all probability, more expensive future lending.

Second, empirical evidence indicates quite unequivocally that excessive liquidity favours increased business and/or investment risk, thereby creating the conditions for ‘bubbles’ in the real estate market, the stock exchange market and other assets such as cryptocurrencies.

Third, the protracted period of low interest rates limits the ability of banks to generate profits and value for their shareholders, especially during a period of intensifying regulatory and capital requirements and limited flow of new loans due to the pandemic.

In conclusion, the rapid and decisive response to the pandemic has contained the development of a more intense crisis. Simultaneously, however, it has created a backdrop that allows bond markets to offer a disproportionate advantage to economically vulnerable states.

This is why every country, including Cyprus whose sovereign debt has reached 120 per cent of GDP, needs to develop a realistic adjustment strategy in order to lead its public debt to a steady downward trend, while continuing to support its key growth pillars.

Andreas Charalambous is an economist and a former director of the Ministry of Finance. Omiros Pissarides is the managing director of PricewaterhouseCoopers Investment Services