While I believe that eliminating QE is the right thing to do for the long-term health of the economy, the recent equity and bond market declines are but modest harbingers of the unintended short-term consequences that the Fed’s prolonged ZIRP/QE program and its termination will wreak – rollover and convexity risk. These are the proverbial pigeons that will come home to roost if the US Federal Reserve stops its massive bond-buying spree and rates normalize.

1. Agcapita Update
July 2013

2. 1
CENTRAL BANKING’S SCYLLA AND CHARYBDIS –
ROLLOVER AND CONVEXITY
The idea that the developed world, beginning with the US, might
just be contemplating a reduction to its unprecedented monetary
stimulus has shaken the confidence of investors. Clearly the die-
hard Keynesians at the Federal Reserve would like to have their
cake and eat it too in the form of artificially low interest rates,
real economic growth and no asset bubbles, but the market
increasingly seems to be in the mood to deny them nirvana.
While I believe that eliminating QE is the right thing to do for the
long-term health of the economy, the recent equity and bond
market declines are but modest harbingers of the unintended
short-term consequences that the Fed’s prolonged ZIRP/QE
program and its termination will wreak – rollover and convexity risk.
These are the proverbial pigeons that will come home to roost if
the US Federal Reserve stops its massive bond-buying spree and
rates normalize.
Sovereign borrowers have had unlimited privileges over the last
two decades. Those privileges are gradually being revoked as the
ability to repay is being called into doubt. Without the ability to
roll over their obligations at current historically depressed interest
rates, the truly precarious nature of sovereign finances will be
revealed. Consider that while interest rates for many developed
nations are at generational lows, sovereign debt loads as a
percentage of GDP are at all time highs.
The Scylla of our story today is what happens to western
governments when their borrowing costs go from 2% to
something approaching the long-term historical average of 5%?
In countries like Japan and the US, the answer is that the majority
of the budget would be dedicated to simply paying interest.
Perhaps this sounds alarmist and unlikely. But consider that, as
of 2012, US federal government debt exceeds US$ 15 trillion.
In 2011, the US government paid US$ 454 billion in interest (an
implied rate of 2.9%). The Congressional Budget Office notes
Agcapita Update

3. 2
Agcapita Update (continued)
that federal government debt will rise to US$ 20
trillion by 2015. If we assume that it carried a rate of
5% instead of 3%, interest payments would total US$
1 trillion or 45% of current tax revenues.
According to a report by Incrementum “Even more
striking is the over-indebtedness situation in Japan.
As a result of the zero interest rate policy being
in force for 17 years by now, the government has
already refinanced the bulk of its debt burden at
extremely low interest rates. Despite such favorable
financing conditions, debt service costs already
amount to 25% of tax revenues. An increase of the
average refinancing costs by three percentage points
(to 4.6%) would consume the entire public revenue.”
Of course, these debt numbers understate the issue
significantly. It is estimated that the present value
of all future US expenditures (including such items
as social entitlements and pensions etc.) less all
currently contemplated future tax revenues, amounts
to more than a US$ 200 trillion deficit. Now imagine
this is funded with debt carrying 5% interest, then the
annual interest bills would be US$ 10 trillion or 500%
of current US federal tax revenues. Clearly, maturing
sovereign debt must continue to be refinanced at low
rates for as long as possible otherwise state solvency
starts to come into question.
Rollover risk can be defined broadly as the possibility
that a borrower cannot refinance maturing debt at
all or at least at rates sufficiently low enough to be
serviced. Here is a concrete example of rollover risk
that may be unfolding right in front of us. By 2015,
it is estimated that US$ 15 trillion (50%) of the debt
of the top 10 global debtors will have matured and
must be rolled over. Considering that global GDP is
estimated at US$ 70 trillion, the magnitude of this
number begs the questions: how will this maturing
debt be re-financed and, perhaps more importantly,
at what interest rates?
Although the US bond market appears well bid for
now courtesy of the US Federal Reserve, private
lenders are not so sanguine. They are retreating from
peripheral markets at the first hint of trouble. If this
continues, either the monetary authorities will have to
continue to monetize maturing debt or interest rates
will have to rise considerably from current historic
lows. We have seen this on a relatively modest scale
in the southern EU countries – what would happen if
this goes global (see the recent spike in yields in the
US and Japan)?
I believe politicians have finally started to sense the
rollover end game is underway; hence the concern
around keeping interest rates low by having central
banks intervene in the bond market. But by keeping
rates low over extended periods of time to allow
financially constrained governments to roll debt
at manageable rates central banks are forcing the
world’s fixed income investors to accumulate every
greater portfolios of low yielding bonds which leads
directly to the Charybdis.
The world’s monetary authorities have been engaging
in ZIRP for almost 5 years now. The longer this takes
place the greater amounts of maturing, higher yielding
debt that are replaced, by necessity, with new
sovereign debt at historically low yields – according to
Incrementum once again “in July 2012, 10-year yields
in the US thus reached with 1.39% the lowest level
since the beginning of records in the year 1790. In
the Netherlands – which provide the longest available
time series for bond prices – interest rates fell to a
496 year low. In the UK, ‘base rates’ are currently

4. 3
Agcapita Update (continued)
at the lowest level since the founding of the Bank of
England in 1694. In numerous countries (Germany,
Switzerland), short term interest rates even fell into
negative territory.”
In addition, with yields on shorter-term sovereign
debt virtually non-existent, bond investors (primarily
pension plans struggling to meet growing benefit
obligations) have been forced to increase the duration
of their portfolios – chasing the marginally better
yield, regardless of how minimal, of longer dated
instruments.
It is important to note that the bond market dwarfs
the public equity markets – sovereign debt is the
largest asset class in the world. So why the recent
panic over an approximate 70 bps move in US
interest rates, surely such a large asset class with its
pool of sophisticated investors is prepared to deal
with such changes? Through the process of replacing
higher yielding maturing debt with new debt at ZIRP
distorted rates and at longer maturities in an attempt
to generate any yield at all, traditional bond investors
are creating portfolios of lower yield, higher convexity
and higher duration.
The issue of convexity is central to the crisis that
normalizing rates will bring to the pension industry.
In very simple terms, convexity is a straightforward
concept to understand – all things being equal, a
move from 1% yield to 1.5% yield causes a greater
drop in the price of the underlying bond than a move
from 7% to 7.5%. For the more mathematically
inclined – delta is the first derivative with respect to
yield (often referred to as the dollar value of a basis
point and this is usually based on a $1MM notional
amount of a particular bond) and convexity is the
rate of change of delta with respect to yield. This
complexity is not relevant to this discussion, simply
the concept that the current global bond universe
is likely to have far higher convexity than the bond
universe of the pre-ZIRP world.
In a nutshell this extra sensitivity to rate increases
with its higher loss potential is the risk that the world’s
monetary authorities have created with their extended
ZIRP programs by forcing bond investors into a lower
yield, higher duration, higher convexity universe–
arguably the most risky configuration possible. When
rates normalize these investors in aggregate will suffer
the perfect storm of losses on underlying portfolios.
If you are still skeptical that pension funds could be
at risk, a recent report by consulting firm Mercer on
the solvency ratio of Canadian pension plans should
provide some perspective. The solvency ratio of
the average Canadian plan fell by 7% in May and as
a consequence that most plans now had negative
solvency ratios. The solvency ratio is “the amount of
money available to pay for earned benefits – known
as liabilities under a plan – compared with the cost of
buying annuities to cover those benefits in the event
of an immediate plan windup.”
Recent yields moves were modest, imagine the
losses that will stem from a return to historical
average yields – arguably 300-500bps higher.
These losses cannot be avoided through financial
engineering – someone has to suffer them. It will be
interesting watch to the world’s monetary authorities
grapple with this conundrum – they can 1) continue
QE and hope that the equity and bond market
bubbles do not come to a violent end or 2) stop QE
causing pension funds to suffer significant losses as
yields normalize which in turn will most likely trigger a
government bailout and more QE.

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