The Mad Genius of the Zero-Forever Bond

 

That the developed world governments are accumulating debt shouldn’t be news to anyone. To give you an idea of the proportions involved, during the Obama administration, US government debt has risen from approximately $8 trillion, accumulated over the previous 218 years of the US’s existence, to above $19 trillion and counting.

This is a 137% increase in merely seven and a half years.

Furthermore, we have now reached the point in time when Baby Boomer-related entitlements are adding to the outstanding cumulative debt. It is projected that the present value of unfunded federally obligated benefits is somewhere between $55 and $222 trillion — currently serviced by an undersized income stream of only $17 trillion.

In this state of indebtedness, the interest bill alone becomes an impediment to being able to fund entitlements (as well as everything else) unless there are some tricks up the government’s sleeves — and they are tricksters.

And here is the trick: Central banks of the developed world are pursuing ultra-low interest rates to reduce the interest burden of their governments’ debt. Indeed, Germany’s effective borrowing rate on the entirety of its debt has declined to .43 of 1 percent, and is now able to come to the market with a 10-year, zero-rate offering that will reduce it even further.

Another means to reduce the debt burden is to play games, not just with reducing interest carry but also with debt maturities. With interest expense being so cheap, there is the natural inclination by the debt managers in the US Treasury and all highly indebted countries to lock in the low rates for as long as possible.

Hence, government bond maturities are being reconsidered. The longest maturity bond of fiscally solid governments that could be sold in markets to private wealth sources had been 30 years, and few governments were able to extend debt that far out.

Or not? First, the 30-year bond maturity was stretched to 50 years in Spain and Italy, neither of which should be considered investment grade. And now France, Belgium, and Mexico have introduced “Century Bonds” — a quaint title — for debt that won’t come due for 100 years.

So the issue of how the interest cost of the debt will be handled is being settled by the mad geniuses in the world’s treasury departments. Expect to see governments placing debt maturities as far out into the future as they can. Selling debt maturities of 30 years, 50 years, or even 100 years is amateurish. The ultimate goal is to stretch the maturity into perpetuity.

And combining a zero-interest rate with a maturity of forever makes for what might be called the “Zero-Forever Bond,” which means no interest or principal will ever be owed or paid.

And here are some of the implications.

The appeal to the government issuer is that debt refinanced as a Zero-Forever Bond is the functional equivalent of a repudiation of its debt. The debt remains on the government balance sheet in perpetuity but with no consequence for the issuing government, as neither interest nor principal is ever paid. At the same time, the Zero-Forever Bond remains an asset for its owner, who never receives interest or principal.

But who would possibly purchase a Zero-Forever Bond?

To answer that question, realize that the great majority of government debt is typically placed with financial institutions that are in the business of store-housing private savings. Their combined balance sheets are well more than that of the central bank.

But without economic incentives for a private financial institution to purchase the Zero-Forever Bond, the governments would need to create some.

This is easily accomplished by financial regulation — and, in fact, it’s already underway. Just require financial institutions to appear “safe and sound,” by requiring them to purchase government debt instead of holding “risky” debt.

In addition, enticements are being given to the money market mutual funds (MMMFs) that must hold significant proportions of Treasury bonds in order to receive government insurance against shares declining to less than “a buck.”

Similarly, insurance companies are generally required to hold conservative portfolios (for which Treasuries fit the bill) and additionally Treasuries offset insufficient surplus in order to remain in regulatory capital compliance. The regulatory presumption that Treasuries are safe and sound is also used for pension fund compliance to be eligible for Federal Pension Benefit Guarantees. The Zero-Forever Bond fits the regulatory bill for all.

Basically, the Zero Forever has two sides to it: It saves the government from an actual default no matter how large its debt relative to tax proceeds because it pays nothing. But if held by private financial intermediaries as described above, they will be challenged to make good on their commitments to private savers because they won’t earn investment income on those assets held as Zero Forever Bonds (and yet, they’d be required to hold them to be in compliance).

The Zero-Forever Bond is not unlike achieving ultimate zero in other fields that causes relationships to be reversed.

In paraphrasing physicist and economist Gary Shilling, who, while commenting in his Insight publication on the central bank pursuing zero short term rates in September 2011, noted:

“….there is an analogy between interest rates near zero and temperatures near absolute zero where all activity of sub-atomic particles ceases…. Near that temperature, strange things happen [italics added]. Thermal energy arises from the motion of atoms and molecules as they collide, but at low temperatures, they don’t and atoms act identically like a single super atom. Substances that are magnetic at higher temperatures become nonmagnetic, and vice versa. Some nonconductors become super conductors — that’s why some computers are kept very cold. Others become super fluids that seem to defy gravity by crawling up the sides of their containers. Near absolute zero, a gas becomes a super liquid that can leak through solid objects….”

Well, the Zero-Forever as a perpetuity bond, which bears no interest and is crammed down on financial institutions that hold private savings, must be considered a change in nature, and in Shilling’s words would cause strange things to happen.

This effectively cancels government debt and thereby increases the net wealth of the government sector. This is done at the expense of the wealth of the financial institutions entrusted with private savings because they must hold an asset that produces absolutely nothing, compromising institutions’ obligations to private savers.

This is how governments’ prospective default is shifted to the private sector. And it’s already happening.

This is being accomplished by some Mad Geniuses in the Treasury Departments of various debt-strapped governments. It requires no public discussion, no legislation, no warnings, and no apologies. It is all quietly slipped under the rug, so to speak.

You will never hear much about it until your insurance company, pension fund, bank, or money market mutual fund is unable to deliver on its contractual obligations to you. And these institutions, not the government, will be held accountable.

Read more from Professor Lew Spellman at The Spellman Report.

Disclaimer

The views expressed are those of the author and not necessarily The University of Texas at Austin.
 

About The Author

Lew Spellman

Professor, Department of Finance, McCombs School of Business, The University of Texas at Austin

Lewis Spellman received his BBA and MBA from the University of Michigan and his MA and Ph.D. from Stanford University. His research interests include...

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