Playing Against the House

By Shane Shepherd

JUNE 2012 Read Time: 10 min

Normally, I’m too much of a rational economist to spend long periods of time in a casino—I just can’t get past the idea of a negative expected return. But several days ago while in Las Vegas for an academic conference, I decided to drop a few chips on the roulette table. Impulsively, I put the entire amount on number 33, recalling the jersey worn by Grant Hill, my favorite basketball player while I was in school at Duke University. Amazingly, the little silver ball came to rest on that very number and my loose change paid out 35 times the original bet!

Somewhat perversely, one of my greater insights of the week came at the roulette table rather than from one of the academic talks. Now, I certainly am not the first observer to draw parallels between investing and gambling in a casino. But the common comparison is to investing in the stock market. Instead, I’d like to discuss how the sovereign debt markets can resemble playing against the house.

House Rules
At a casino, the house sets the rules and governs the payouts. They have decided that my winning bet pays 35-to-1 (giving me about a –5% expected return), instead of a fair rate of 37-to-1 (which would provide a 0% expected return). And the rules of the game can change. In Monte Carlo, roulette wheels have only a single green zero, while the Las Vegas casinos have added a green double-zero. The subtle impact is to slightly reduce the probability of any single number hitting, though the payout remains constant at 35-to-1, thus boosting the casino’s expected profits (and increasing my expected losses). A small change to the rules of the game tilts the profits more heavily in the casino’s favor.

One of the crucial differences between investing in sovereign debt issues instead of investing in, say, corporate bonds or stocks is that you are, in a sense, playing against the house rather than against other market participants. For example, when a corporation issues a bond, the capital markets establish the appropriate yield on the bonds. The individual company can do very little to influence the coupon or yield on their bonds. And, to the extent the market functions well, the company will pay an appropriate cost of capital and the purchasers of its bonds will receive a free and fair market return for bearing the risk associated with that bond.

In order to set fair prices, efficient markets require market participants that are not constrained and base their buying and selling decisions on a balance of risk and return. The presence of large non-economic participants that have no regard for a return to risk destroys one of the core assumptions underlying efficient capital markets. Like it or not, governments have the power (and with increasingly high debt burdens, increasing motivation!) to create non-economic regulations and incentives that tilt the rules of the game in their favor. Massive amounts of quantitative easing around the globe are examples of this behavior. In the United States, the Federal Reserve implemented “Operation Twist” with the stated goal of lowering the yields on long-term government bonds: Their expressed intent was to push prices away from an efficient market outcome. Their motivation may be a noble one, to stoke the engines of the U.S. economy and provide impetus for job creation. The pernicious side effect, however, is to reduce the profits to investors and increase the profits to the “house”—a transfer of wealth from savers and into the hand of borrowers—chief among them the U.S. Treasury.

Sovereign Influence
Quantitative easing is but one recent example of what economist Carmen Reinhart and others1 have described as “financial repression.” Broadly speaking, the term refers to government policies that channel funds toward their own debt, typically at below-market rates. These policies do not have to be direct market activities. Other examples include imposing ceilings on interest rates, regulating direct lending to the government by captive domestic audiences such as pension funds or banks, and restrictions on cross-border capital movements.

The current period is not the first time in modern history that our global economy has been faced with crushing debt burdens. In their paper “The Liquidation of Government Debt,”2 Reinhart and Sbrancia describe the historical context of financial repression in the post-World War II era. After running high deficits to finance the war, governments tried to return their fiscal houses to order. Government policies such as Regulation Q in the United States capped interest rates, and the heavy capital controls associated with the Bretton Woods system kept domestic savers captive in their home markets. This combination of suppressing interest rates and incentivizing or regulating debt purchasers led developed economies to incur negative real interest rates in about half of the 1945–1980 period. Negative real interest rates provide low costs of borrowing as well as liquidate the existing stock of debt. Reinhart et al. measure the amount transferred from savers to government borrowers by multiplying these negative real rates by the stock of government debt.3 To put the size of this wealth transfer in context, Table 1 displays for a few countries the size of the savings as a percentage of GDP and as a percentage of government taxes.

As we can see, the impact of this financial repression was large and long-lasting. Averaging over 3% of GDP for these years, the size of the savings means that a country with 100% debt-to-GDP could reduce its debt burden to below 70% of GDP over the course of a decade. Alternatively, if savings were equivalent to 20% of tax revenues, governments would reduce their debt obligation by the commensurate amount without needing to raise taxes (and, thus, avoiding the accompanying drag on economic growth). Finally, we see that the incidence of negative real interest rates was not a short-term cyclical effect but rather a very long lasting paradigm shift, requiring investors to alter their capital market expectations and strategies for over three decades.

Financial Repression and Real Rates
Financial repression is the easiest, most politically expedient path toward dealing with our global debt problem. Many of the world’s developed economies are on a collision course with insolvency (if not already there!), and the escape routes are not attractive to policymakers. Consider the options: Austerity is a long, painful road that requires a hit to GDP and economic prosperity as debt burdens decrease. This solution has not worked in Greece, and we certainly don’t expect any governments with access to a printing press to go down that path with any sustained vigor. Explicit default may occur in countries, such as those tied to the euro, that cannot print money or influence their market interest rates. Inflating away the debt is often talked about as an alternative, but in reality inflation on its own will not achieve that goal. Expected inflation is quickly incorporated into long-term interest rates, so costs of borrowing tend to rise along with inflation. And inflation is only helpful in reducing the value of long-term debt, not short-maturity debt. But government regulation to artificially hold interest rates low, along with a steady dose of not-too-high inflation, will work—and is a far stealthier alternative than raising taxes or chopping government spending programs.

We are not arguing for or against the relative merits of the financial repression route. But clearly we are already witnessing a move in that direction. A few examples: in 2009, the United Kingdom increased the required holdings of gilts for its banks and their subsidiaries; the recent Basel III regulations provide preferential treatment for (supposedly) risk-free sovereign debt on a bank’s balance sheet; in 2010, Spain imposed interest-rate ceilings on bank deposits; and Japan reversed its planned privatization of Japan Post, the largest holder of personal savings in the world and a huge captive buyer of Japanese government bonds. These sorts of regulations, along with the massive purchases of government bonds by the world’s central banks, are starting to have their intended effect. As can be seen in Figure 1, expected real interest rates for several countries around the globe are predominantly negative.

With short-term interest rates close to zero, investors are earning a significantly negative real return across most developed economies. And most countries, except those countries such as Italy where default risk reflects a premium, and Japan where expected inflation is close to zero, show negative real rates even at the 10-year horizon. While this situation is undoubtedly a great boon to the world’s borrowers, and perhaps encouraging of economic growth, it’s an unmitigated disaster for savers. To eke out any sort of positive real return requires historically low levels of inflation for a sustained period—in a world with a dramatically increasing money supply. One just might experience better odds at the roulette wheel.

What, then, is an investor to do? Rather than passively play the house’s game, we need to take steps to tilt the odds back in our favor. In the sovereign debt markets, the financial repression solution will be most severe in the countries that are most indebted and control their own currency. Investors in a cap-weight sovereign bond index fund are, in effect, allowing the house to set the rules. They place their largest allocations into the countries with the largest debt burdens, where these problems will be most prevalent.

A simple shift of the rules can greatly mitigate this exposure. The Citi® RAFI Bond Index Series determines country exposure by fundamental measures of country size, which are correlated with a country’s debt service capacity. By weighting according to a combination of GDP, population, land area, and energy usage, these indices gain exposure to large economies rather than large debtors, and enjoy a return advantage over their cap-weight counterparts. Historically, a fundamentally weighted index in the developed sovereign market has outperformed by 80 bps annually and in emerging markets sovereigns by 125 bps annually.4

Not only have fundamentally weighted indices outperformed traditional bond indices, but they do so with a lower risk exposure. Traditional indices load up on debt from the largest debtors, and thus tend to have increased credit risk. They also tend to have longer duration risk as governments lock up their debt obligations for longer periods of time, thus the cap-weighted indices have more exposure to interest rate risk. In most circumstances, a less creditworthy issuer with greater interest-rate exposure would have to pay a higher yield on their bonds. But, as we have seen, the largest debtors are the ones most likely to exert influence to keep their yields low—thus increasing the house’s take and reducing investors’ “winnings.” By sidestepping these house-imposed rules and reducing exposure to the “financial repression tax,” the fundamentally weighted sovereign debt indices become the rarest of all birds in the financial markets—strategies that have provided increased return while reducing risk!

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1. Reinhart, Carmen M., Jacob F. Kirkegaard, and M. Belen Sbrancia. 2011. “Financial Repression Redux.” Finance & Development, vol. 48, no. 1 (June):22–26.
2.  Reinhart, Carmen M., and M. Belen Sbrancia. 2011. “The Liquidation of Government Debt.” National Bureau of Economic Research Working Paper 16893 (March).
3. This calculation gives a conservative measure, essentially assuming that a fair market real rate would be 0%.
4. Returns in unhedged USD. Developed sovereign data reflects the Citi® RAFI Developed Sovereign Bond Index, 2001–2011; Emerging sovereign data from Research Affiliates and Bloomberg, 2002–2011.